Polycorp Limited Steel Division is considering a proposal to purchase a new machine to manufacture a new product for a potential three year contract. The new machine will cost $1 million. The machine has an estimated life of three years for accounting and taxation purposes. The contract will not continue beyond three years and the equipment estimated salvage value at the end of three years is $100,000. The tax rate is 30 percent and is payable in the year in which profit is earned. An investment allowance of twenty percent is available. The after tax cost of capital is 13.5% pa. Ignore inflation.
Addition net working capital of $60,000 is required immediately to support the project. Assume that this amount is recovered at the end of the three year life of the project.
The new product will be charged $52,000 of allocated head office administration costs each year even though head office will not actually incur any extra costs (or cash flows) to manage the project. This is in accordance with the firm's policy of allocating all corporate overhead costs to divisions.
Extra marketing and administration cash outflows of $40,000 per year will be incurred by the Steel Division.
An amount of $30,000 has been spent on a pilot study and market research for the new product. The projections provided here are based on this work.
Projected sales for the new product are 30,000 units at $115 per unit per year. Cash operating expenses are estimated to be 80 percent of sales (excludes marketing and administration, and head office items).
Except for initial outlays, assume cash flows occur at the end of each year (unless otherwise stated). Assume prime cost or straight line depreciation for tax purposes.
(a) Construct a table showing your calculations of net cash flow after tax. (Similar to that demonstrated in the notes and in class)
(b) Calculate the NPV. Is the project acceptable? Why or why not?
(c) Explain your calculation of relevant net cash flows after tax, justifying your selection of cash flows. Be sure to state clearly any assumptions made.