Baby Johnson inherited his soap company from his father about ten years ago. His father had in turn inherited the company from his father. The company currently has 125 Soap dispensers in the institution located in Crown. In order to be able to run this many dispensers and ensure they produce soap in a timely manner the company employs two extra hands on a part-time basis. These employees work 25 hours a week and are paid $20 an hour. They each work 48 weeks a year and receive superannuation at a rate of 9.5% of their gross pay.In order to make his life a little easier ,Johnson has decided to purchase an automatic rotor soap dispensing machine. The machine with the most potential is the Rotor 700. To facilitate this purchase, Johnson has employed theservices of BOOST junior to analyse the viability of such an investment. Boost's report is $50,000. $30,000 was paid before the report wasprepared and a further $20,000 was to be paid if the decision was made toundertake the project. Other costs incurred by MrBoost junior include the cost offlights from Sydney to London and appropriate accommodation. He will fly firstclass and these flights will amount to $10,000. Economy class fares are $3,000.Accommodation, meals and incidentals will cost $3,000. These costs will beincurred before the decision is made.
MrJohnson's tax advisor is MrPODS CPA. He has advised that theentire cost of Boost's report is 100% tax deductible while 75% of the flights aretax deductible and the other costs associated with the report are 50% deductible.
The new machine will cost $500,000 and can be depreciated straight line over 10years for tax purposes. Accounting depreciation is 15% reducing balance. Mr PODS has recommended that the 15% reducing balance depreciation rate beused for any analysis.
Details of the project are as follows:
- MrJohnson will also need to build a new shed to house the dispenser machine. This will cost $100,000 and can be depreciated for tax andaccounting purposes over 5 years straight line.
- The area where the shed will be built previously housed a machineryparking lot. Currently this is leased to the next-door neighbour for $1000per month but Johnson had renegotiated this with him and the neighbor was prepared to pay $1500 per month from now on.
- Delivery and installation costs will be $100,000. MrPods believes thatthese should be expensed although the ATO has advised this need to be included in the value of the machinery for depreciation purposes. MrPod's is adamant that these must be expensed and a 50% tax deduction isavailable.
- MrHarrison will provide management of the new facility. He will bepaid $75,000 per annum (inclusive of superannuation) and this will increaseby 10% per annum. The two employees at the beginning will no longer be needed and willbe paid a redundancy of $10,000 each (with no superannuation payable)when the new machine is purchased. These redundancy payments are taxdeductible immediately.
- The new machine will be able to be sold for $50,000 at the end of theprojects life in year 10. The shed will be worthless at the end of the project.
- The advantage of the new machine is that the Company will be able to increasethe number of Soap dispensers from 125 to 250. It also means that the farm will beable to increase soap production from 1 million to 1.5 million litres. In yearone, Soap will sell for $1 per litre and increase by 10% per year from year 2onwards. The company will also be able to produce 200,000 litres of Shampoo.This will sell for $2 per litre and is expected to increase by 5% per annumfrom year 2 onwards. In year 5, the number of Soap dispensers will increase to 300.This will result in a 20% increase in output.
- Sales of Soap bars will, however, fall by $250,000 per year. Soap bar prices wereexpected to increase by 6% per year from year 2 onwards. This means thatlost sales were also expected to increase by 6% per annum.
- MrJohnson will run tours of the new facility and these are expected togenerate revenues of $100,000 per annum.
- The project is expected to need an increase in working capital from$100,000 to $200,000 initially.
- Costs of production (company costs) are 30% of net sales of soap, shampoo and soap bars.
- Tools currently used in another part of the company will be used with the newmachine. These used tools have a market value of $10,000 but will need tobe replaced with new tools. These are expected to cost $20,000. Theseare currently depreciated for tax purposes over 2 years and will have nosalvage value.The Company maintains a photo library at its office in the main street of Crown. The company devotes one floor of its office to this library, which contains copies of some of the most beautiful photos taken in Crown over the last 50 years. The rent iscurrently $10,000 per year.The Company plans to borrow 100% of the funds required to purchase the newmachine from Commonwealth. Interest rates are expected to be 8% per annum fixed forthe life of the loan. All interest payments are tax deductible. The loan will be aninterest only 10-year loan with the full amount repaid in year 10.The company maintains a constant debt-to-equity ratio of 60%. The cost of debt forthe farm is 8% per annum. The real rate of return of the ASX200 index is 10% paand the real rate of return on government bonds is 3% pa. The beta of the farm is1.5. Projects such as this typically require an additional 2.5% premium on top ofthe firm's WACC
Note:
- The current rate of inflation is 3.0% p.a. pays tax at 30 cents in the dollar.
- All tax benefits are received in the year in which the expenditure is incurred unless otherwise stated.
- All amounts and interest rates are in real dollars and percentages.
- All analysis should be undertaken in real dollars.
(a) Calculate the cash flows at the start of the investment (t=0
(b) Calculate the cash flows over the life of the investment (t=1,2,3...9)
(c) Calculate the cash flows at the end of the investment (t=10).