SUBMITTED BY:

Qaisar Shahzad
SUBMITTED TO:
Dr. Haroon Hussain Sb.
ROLL NO:
(MCOF19M008)

SUBJECT:
Corporate Finance
PROGRAM:
M.COM 3rd

ABC Company is considering the replacement of old machine that is 3 three years
old with a new, more efficient machine. The two old machines could be sold
currently for a total of $75,000 in the secondary market, but they would have a
zero final salvage value if held to the end of their remaining useful life. Their
original depreciable basis totalled $320,000. They have a depreciated tax book
value of $86,400, and a remaining useful life of eight years. MACRS depreciation
is used on these machines, and they are five-year property class assets.

The new machine can be purchased and installed for $500,000. It has a useful life
of eight years, at the end of which a salvage value of $70,000 is expected. The
machine falls into the five-year property class for accelerated cost recovery
(depreciation) purposes. Owing to its greater efficiency, the new machine is
expected to result in incremental annual operating savings of $170,000 (10 percent
inflation in cash flows is expected). The company’s corporate tax rate is 40
percent, and if a loss occurs in any year on the project, it is assumed that the
company can offset the loss against other company income.

Following additional information is provided:

Annual maintenance cost on old machine is 3000$ whereas annual maintenance

cost on new machine is expected to be 4000$ for first year which may increase by
500$ every year. New machine may require engine overhaul in year 5 which my
cost 10,000$ every year. The cost of defects due to old machine were 500$ per
year whereas the cost of defects using new machine would be 500$ for first year,
1000$ for the second year and an increase of 500$ every year son one till year 8.

Due to replacement, following additional costs are required:

 a. Additional cash holdings = 8000 $

b. Additional investment in inventory = 4000 $

c. Concrete foundation for new machine = 1000$

d. Training of new machine operator = 500 $

e. Shipping of new machine to plant site = 300$

Electricity cost may reduce by 800 units per year where per unit electricity cost is
3$ per unit. However, this cost saving will decrease by 100 units per year.

SOLUTION
5 Years MACRS = 20 %, 32%, 19.2%, 11.52 %, 11.52 %, 5.76%

Initial cash outflow:

Price of new machine: 500,000$

Add: shipping cost + 1000$

Add: concrete foundation + 300$

Total cost of new machine 501300 $

Less: Sale price of old machine - 75000 $

= 426,300 $

Add: cash holding 8000 $

Add: additional investment 4000 $

Add: training of new machine operators 500 $

438,800 $

Less: Tax shield - 4560

(11400*40/100)

Net Cash outflow 434,240

 0 1 2 3 4 5 6 7 8
(434,240) 170,000 187000 205700 226270 248897 273787 301166 331283

Maintenance(old) 3000 3000 3000 3000 3000 3000 3000 3000

Maintenance(new) 4000 4500 5000 5500 6000 6500 7000 7500
Inc.Maintenance (1000) (1500) (2000) (2500) (3000) (3500) (4000) (4500)
Engine overhaul (10000) (10000) (10000) (10000)
Eiecricity cost 2400 2100 1800 1500 1200 900 600 300
Cost of 500 500 500 500 500 500 500 500
defects(old)
Cost of defects 500 1000 1500 2000 2500 3000 3500 4000
(new)
Inc.cost of defects 000 (500) (1000) (1500) (2000) (2500) (3000) (3500)
Depreciation (old) 36864 36864 18432
Depreciation (new) 100260 160416 96250 57750 57750 28875
Inc.Depreciation (63396) (123552) (77818) (57750) (57750) (28875)
Total (434,240) 108004 63548 126682 166020 177347 229812 284766 313583
Tax Rate (43202) (25419) (50673) (66408) (70939) (91925 (11390 (125433
) 6) )
Salvage 42000
Additional cash 8000
holders
Additional 4000
investments in
inventory
Inc.depreciation 63396 123552 77818 57750 57750 28875
Incrementle cash (434,240) 128198 161681 153827 157362 164158 166762 170860 242150

The company has decided to finance this project by borrowing 30 percent of funds
required
by borrowing 30 percent of funds required at 12 percent. Likewise, 30 percent of
funds
required are raised by issuing preference shares at 13 percent.
Remaining funds would be acquired by issuing common stock. The 6 months
Treasury bill rate is 10 percent and market required rate of return is 18 percent.
The beta for the ABC company stock is 1.2;
you are required to estimate the incremental net cash flows and decide the
acceptance/rejection of this project by applying relevant capital budgeting
techniques.

Total cash out flow: 434,240

Total cash in flow

Years
1. 128,198 $
2. 161,681 $
3. 153,827 $
4. 157,362 $
5. 164,158 $
6. 166,762 $
7. 170,860 $
8. 242,150 $

A. PAY BACK PERIOD

Years = cash out flow - cash inflow

1. 434240 - 128,198 = 306042 $
2. 306042 - 161,681 = 144361 $

3. 144361 / 153,827 = 0.9385

Total pay back period = 2year + 0.9385

= 2.9385 years

B.NET PRESENT VALUE

 NPV :

WACC = (Wd)(Kd)(1-t)+(Wp)(Kp)+(We)(Ke)
= (0.3)(0.12)(1-40%)+(.30)(0.13)+(0.4)(19.6%)
= 0.139
= 13.9 %

CAPM = Rf+b(Rm-Rf)
= 10%+1.2(18%-10%)
= 19.6 %

Net present value:

= 750,976 - 434,240
= 316,736

0 1 2 3 4 5 6 7 8

(434240 128198 161,681 153,827 157,362 164,158 166,762 170,860 242,150

)

PV of (128198)/ (161,681) / (153,827 (157,362 (164,158 (166,762 (170,860 (242,150)

inflow (1.139)^1 (1.139)^2 )/(1.139) )/ )/ )/ )/ /
^3 (1.139)^ (1.139)^ (1.139)^ (1.139)^ (1.139)^8
4 5 6 7
85485.94
112553 124627 104102 93499 85633 76375 68702

PV of Inflow = 750976
 C. INTERNAL RATE OF RETURN ( IRR)

NPV at 13.9 % = 316,736

NPV at 35% = (33653)

At 35 %:

0 1 2 3 4 5 6 7 8

(434240) 128198 161,681 153,827 157,362 164,158 166,762 170,860 242,150

PV of (128198) (161,681)/ (153,827)/ (157,362)/ (164,158)/ (166,762)/ (170,860)/ (242,150)/

inflow /(1.35)^1 (1.35)^2 (1.35)^3 (1.35)^4 (1.35)^5 (1.35)^6 (1.35)^7 (1.35)^8

94961 88714 62521 47377 36609 27548 20908 21949

NPV at 35%= 400587-434240 = ( 33653)

=iL+( iH-iL )(NPV-NPV ytm)/(NPVL-NPVH)

= .139+[(.35-.139)(316736-0)/(316736+33653)]

= 32.97 %

This project is acceptable.

D. PROFITABILITY INDEX
 = 750976/434240
= 1.72940

PROJECT SUMMARY

1. Macrs rates
= 20.00%, .32%, 19.20%, 11.52%, 11.52%,5.76 %

2. Incremental cash flows

= out fow 434240
= cash inflow ($)

161,681 153,827 157,362 164,158 166,762 170,860 242,150

3. CAPM
19.6%
4. WACC
13.9%
5. NPV
= 316736
6.IRR
= 32%
7. Profitability index
= 1.72
8. Pay back period
= 2.93 year

 PROJECT IS ACCEPTED