TUTORIAL: Capital budgeting: Cash flow principles

QUESTION 1
Delta Inc. is considering the purchase of a new machine which is expected to increase sales by $10,000 in
addition to increasing non-depreciation expenses by $3,000 annually. Due to the sales increase, Delta
expects its working capital to increase $1,000 during the life of the project. Delta will depreciate the
machine using the straight-line method over the projects five year life to a salvage value of zero. The
machines purchase price is $20,000. The firm has a marginal tax rate of 34 percent, and its required rate
of return is 12 percent.
a) The machines initial cash outflow is:
$21,000.
b) The machines incremental after-tax cash inflow is:
$5,980.
c) The machines after-tax incremental cash flow in year five is:
$6,980.
d) The machines NPV is:
$1,123.99.
e) The machines IRR is:
greater than 12 percent.
QUESTION 2
A firm is trying to determine whether to replace an existing asset. The proposed asset has a purchase price
of $50,000 and has installation costs of $3,000. The asset will be depreciated over its five year life using
the straight-line method. The new asset is expected to increase sales by $17,000 and non-depreciation
expenses by $2,000 annually over the life of the asset. Due to the increase in sales, the firm expects an
increase in working capital during the assets life of $1,500, and the firm expects to be able to sell the
asset for $6,000 at the end of its life. The existing asset was originally purchased three years ago for
$25,000, has a remaining life of five years, and is being depreciated using the straight-line method.
However, the current sale price of the existing asset is $20,000, and its current book value is $15,625. The
firms marginal tax rate is 34 percent and its required rate of return is 12 percent.
a) Increased taxes on the sale of the old machine are:
$1,487.50.
b) The net initial outlay if the new asset is purchased is:
$35,987.50.
c) The incremental change in depreciation is:
$7,475.
d) The net incremental after-tax cash flow is:
$12,441.50.
e) The after-tax terminal cash flow is:
$14,601.50.
f) The NPV for this replacement decision is:
$10,086.97.

QUESTION 3
Use the following information to answer the next 4 questions.

A firm is trying to determine whether to purchase a new machine. The proposed machine has a purchase price of
RM100,000, installation costs of RM20,000 and shipping cost of RM30,000. It also require an additional cost of
RM5,000 for training. The machine will be depreciated over its five year life using the simplified straight-line method.
The new machine is expected to increase sales by RM200,000 and cost of maintenance by RM150,000 annually
over the life of the asset. Due to increase sales, the firm expects an increase in working capital during the machines
life of RM10,000 and the firm expects to be able to sell the machine for RM20,000 at the end of its life. Finally, to
purchase the new machine, it appears that the firm would have to borrow RM30,000 at 7% interest from its local
bank, resulting in additional interest payments of RM2,500 per year. The firms marginal tax rate is 40% and its
required rate of return is 12%.
a) Calculate initial outlay
RM165,000
b) Calculate operating cash inflows.
RM42,000
c) Calculate terminal cash flow (including operating cash inflows)
RM22,000
d) Calculate the net present value the above proposed machine. Should this machine be purchased?
(RM1,120); No