Janice Joplin owns the Radical Music Company and needs a new recording machine as technology is quickly changing.
- The best machines are available in Canada. Janice decides to visit Canada to determine which machine to purchase. The cost of this trip was $12,000. Based on the trip she will purchase the Mendez 100. Once the decision is made to purchase, she will need to travel to Canada to undertake training. This will cost $10,000. Both trips are tax deductible in year 0.
- The Mendez 100 will cost $650,000 and should be able to be sold for $100,000. The accountant has advised that the machine will be depreciated over 7 years. The ATO however requires depreciation over 6 years. It is expected that the machine will be kept for 5 years by Radical Music so any evaluation must be undertaken over a 5-year period. The accountant is adamant that depreciation will need to be over 7 years for analysing this project.
- Janice will need to borrow 50% of the value of the Mendez 100 from the Eastern Bank. The loan will be at a fixed rate of 12% p.a. over 5 years, with interest only payable at the end of each year. The principal is repayable at the end of the fifth year.
- The old machine was purchased three years ago and at that time was expected to have an economic life of 4 years. It cost $280,000 and Janice has been depreciating it using straight-line depreciation over four years as required by the ATO. Janice expects she will receive $120,000 if she sells the old machine. It is expected to be sold in period 0 if the new machine is purchased.
- The Mendez machine is state-of-the-art, and much more efficient than the old machine. The old machine costs $250,000 per annum to operate, whereas the new machine will only cost about $75,000 per annum to operate.
- Due to the different way the Mendez operates, it will be necessary to purchase an additional $80,000 of inventory in year 0.
- Janice will need less staff because of the new machine. This will require a payout of $200,000 in year 0 and save wages of $80,000 per year. These amounts are tax deductible.
- All cash flows are given in nominal terms.
- The nominal rate of interest currently in the economy is 6% and inflation is 3%. The real rate of interest is 2.91% and the WACC is 7%
- The corporate tax rate is 27%. Assume tax is paid in the year of income.
- The new machine will generate yearly revenue of $4m while the old machine was only able to generate annual revenue of $1.9m.
Problem 1) What amount (before taxes) of the trip to Canada should be included when undertaking the NPV analysis?
Problem 2) The after-tax impact from Eastern Bank to be included in the NPV calculation is:
Problem 3) The depreciation tax shield (tax benefit per annum) for the new machine is:
Problem 4) The lost depreciation tax shield (tax benefit per annum) for the old machine is in year 5 is:
Problem 5) Janice must purchase additional inventory. The cash flow impact of this in year 5 will be?
Problem 6) The Cash Flow in period 0 is:
Problem 7) The appropriate discount rate to use in deciding whether Janice should buy the new machine is.
Problem 8) The Free Cash Flow in year 5 is