 Noon Business School, University of Sargodha

CORPORATE FINANCE

NAME:
MUHAMMAD ABDULLAH ZAFAR
ROLL NO:
MCOF19Mo14

A Term Paper Presented In Lieu Of The

Partial Requirement for the Degree Of
Masters in Commerce
 To

Sir HAROON HUSSAIN

Semester: 3rd (Regular)

1
 ABC COMPANY
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 totaled $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 $170,000 (10
percent inflation in cash flows is expected). The
company’s corporate tax rate is 40 percent, and if a
loss occurs in any year on the project, it is assumed
that the company can offset the loss against other
company income. Following additional information is
provided:
1) Annual maintenance cost on old machine is 3000$ whereas annual
maintenance cost on new machine is expected to be 4000$ for first year
which may increase by 500$ every year.

2) New machine may require engine overhaul in year 5 which my cost

10,000$ every year.
3) 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.

4) 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$

5) 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.

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.
 OLD MACHINE

Book Value of old Machine 86400

Sale for -75000
Loss on sale of old Machine 11400

Maintenance cost 3000

 Current Market Price= 75000, 3 years old

 Original price = 320000
 Book Value =86400
 Useful life remaining=8 years, five year property class.

NEW MACHINE
 Cost of purchase= 500000
 Useful life = 8 years, five year property class
 Salvage value=70000
 Incremental annual operating savings cash inflow= 170000
 Inflation expected in cash flow= 10%
 Tax Rate = 40%
 Maintenance cost = 4000 (500 first year which may increase
500 per year.
 Repair of Engine in 5 year = 10000
 ADDITIONAL COST

 Additional cash holding = 8000

 Additional investment inventory = 4000
 Concrete foundation of new machine = 1000
 Training of new machine operator = 500
 Shipping of new machine to plant site = 300

5 YEAR MACRS
 20%
 32%
 19.2%
 11.52%
 11.52%
 5.76%
INITIAL CASH OUTFLOW

New machine price = 500,000

Old machine sale = 75,000
-------------
425,000
Additional cash holding 8000
Additional investment inventory 4000
Concrete foundation of new machine 1000
Training of new machine operator 500
Shipping of new machine to plant site 300
----------- 13800
------------
438800
Tax shield
11400* 40/100 (4560)
------------
Net cash outflow 434240
 0 1 2 3 4 5 6 7 8
CASH FLOW 434240 170000 187000 205700 22627 248897 273787 301166 33128
0 3

OLD MAINTANCE COST (3000) (3000) (3000) (3000) (3000) (3000) (3000) (3000)
NEW MAINTANCE COST (4000) (4500) (5000) (5500) (6000) (6500) (7000) (7500)
INCREAMENTAL CASH (1000) (1500) (2000) (2500) (3000) (3500) (4000) (4500)
FLOW
OVER HOULING COST (10000) (10000) (10000) (10000
)
OLD DEFECTIVE COST (500) (500) (500) (500) (500) (500) (500) (500)
NEW DEFECTIVE COST (500) (1000) (1500) (2000) (2500) (3000) (3500) (4000)
INCREMENTAL DEFECTIVE (0) (500) (1000) (1500) (2000) (2500) (3000) (3500)
COST
ELECTRICITY SAVING 2400 2100 1800 1500 1200 900 600 300
OLD MACHINE (36864) (36864) (18432)
DEPRECTION
NEW MACHINE 100260 160416 96250 57750 57750 28875
DEPRECTION
INCREMENTAL (63396) (123552) (77818) (57750 (57750) (28875)
DEPRECIATION )
434240 108004 63548 126682 16602 177347 229812 284766 31358
0 3
TAX 40% (43201.6 (25419.2) (50672.8 (66408 (70938.8 (91924.8 (113906. (12543
) ) ) ) ) 4) 3.2)
ADD INCREMENTAL 63396 123552 77818 57750 57750 28875
DEPRECIATION
ADDITIONAL COST 8000
HOLDING
ADDITIONAL 4000
INVESTMENT
SALVAGE VALUE 42000
NET CASH FLOW 434240 128198.4 161680.8 153827.2 15736 164158. 166762. 170859. 24214
2 2 2 6 9.8

WACC
Debt 30% 0.3 Kd 12% 0.12
P.Stock 30% 0.3 Kp 13% 0.13
Equity40% 0.4 Ke 17.6%0.176%

WACC(Wd)(Kd)(1-t)+(Wp)(Kp)+(We)(Ke)
WACC(0.3)(0.12)(1-40%) + (0.3) (0.13) + (0.4)(17.6%)
0.131 13.1
13.1%
CAPM
RF+b(Rm-Rf)
20%+1.2(18%-
20%)
20%+1.2(-2%)
20%+1.2(-0.02)
20%+-0.024

17.6%

0 1 2 3 4 5 6 7 8
43424 128198 16168 15382 15736 16415 16676 17085 24214
0 1 7 2 8 2 9 9
128198/ 16168 15382 15736 16415 16676 17085 24214
(1.131)^1 1/ 7/ 2/ 8/ 2/ 9/ 9/
(1.131 (1.131 (1.131 (1.131 (1.131 (1.131 (1.131
)^2 )^3 )^4 )^5 )^6 )^7 )^8
PV.of 113349.2 12639 10632 96172. 88705. 79674. 72177. 90444.
Inflow 6.1 7.3 79 19 89 1328 43
s
Total Inflows:
773247.1

Net present Value:

PV of Cash inflows - PV of cash Outflows
773247.1 - 434240

339007.1

Payback period

Out Flows Inflows 1st year Inflows 2nd year Inflows 3rd year
434240 128198 161681 153827
2nd Year:
= 434240-128198-161681
=144361
rd
3 Year:
=144361/153827
=0.9384
Payback period:
=2+0.9384
=2.9 Years
Payback period = 2 Years and 11 months

Profitability Index
Profitability index = NPV of cash inflows / NPV of cash out Flows

Profitability index = 773247.1/434240

Profitability index = 1.780691

IRR:
= lower rate + (difference in rate (+ve NPV/ (+ve NPV + -ve NPV)
at 13% PV at 39% PV
(1+0.13)^ Pv= (1+0.26)^ Pv=
Year CF n CF/(1+r)^n n CF/(1+r)^n
1 128198 1,130 113450 1,390 92229
2 161681 1,277 126620 1,932 83681
3 153827 1,443 106610 2,686 57278
4 157362 1,630 96513 3,733 42154
5 164158 1,842 89098 5,189 31636
6 166762 2,082 80099 7,213 23121
7 170859 2,353 72625 10,025 17043
8 242149 2,658 91087 13,935 17377
PV 776102 364519
NPV at 13% = 776102 – 434240
341862
NPV at 39% = 364519 – 434240
= -69721

IRR = lower rate + (difference in rate (+ve NPV/(+ve NPV + -ve NPV)
0.13 + (0.26 (341862 / (341862 + (-69721))
0.13 + (0.26(341862 / (411583)
0.13 + 0.21595
0.345
( 35%)