A firm is considering purchasing a new milling machine and has collected the fol
ID: 2575789 • Letter: A
Question
A firm is considering purchasing a new milling machine and has collected the following information for its income statement and cash flow statement. However, this income statement was calculated as if there is no inflation! All dollars are expressed in constant (year-0) dollars. Recalculate the income and cash flow statement by assuming there is a general (average) inflation of 2.7% applied to revenue, O&M, and salvage value.
A firm is considering purchasing a new milling machine and has collected the following information for its income statement and cash flow statement. However, this income statement was calculated as if there is no inflation! All dollars are expressed in constant (year-0) dollars. Recalculate the income and cash flow statement by assuming there is a general (average) inflation of 2.7% applied to revenue, O&M, and salvage value.
- The firm will pay back the loan in 2 years, and the annual loan payment is $09,262. - The tax rate is 33%. - The revenue for year 1 is $37,000 and $33,000 for year 2. - O&M for year 1 is $13,000 and $14,300 for year 2. - The interest paid on the debt is $941 for year 1 and $483 for year 2. - The taxable income is $14,914 for year 1 and $11,237 for year 2. - The income taxes are $4,922 for year 1 and $3,708 for year 2. - The milling machine costs $57,000. - The salvage value at the end of year 2 is $44,000. Calculate the IRR of the cash flow based on actual dollars. Express your answer as a percentage between 0 and 100. You should calculate the depreciation based on the information given in the problem, but do not refer to the MACRS table. You will also need to calculate the amount that is borrowed and that goes to the principal on the debt in years 1 and 2."Explanation / Answer
To recalculate the Income statement after factoring in inflation, let's first make the income statement at constant $ to figure out the depreciation which is assumed to be the balancing figure to reach the taxable income given in the question:
Constant dollars
Year 1
Year 2
Revenue
37,000
32,000
O&M
13,000
14,300
Depreciation (balancing figure)
8,145
5,980
Operating Income
15,855
11,720
Interest
941
483
Taxable income
14,914
11,237
Tax thereon @ 33%
4,922
3,708
Considering an annual inflation rate of 2.7%, the revised income statement for 2 years is working out to as shown below:
Constant dollars
Inflation factor
With inflation @ 2.7%
Year 1
Year 2
Year 1
Year 2
Year 1
Year 2
Revenue
37,000
32,000
102.7%
105.5%
37,999
33,751
O&M
13,000
14,300
102.7%
105.5%
13,351
15,083
Depreciation
8,145
5,980
100.0%
100.0%
8,145
5,980
Operating Income
15,855
11,720
16,503
12,689
Interest
941
483
100.0%
100.0%
941
483
Taxable income
14,914
11,237
15,562
12,206
Tax thereon @ 33%
4,922
3,708
5,135
4,028
In the above calculation, inflation factor for year 2 is 102.7% x 102.7%= 105.5% & inflation factor for depreciation is taken as 100% as depreciation is calculated at historical cost. Also, interest is payable on actual loan taken & hence has inflation factor as 100%.
Amount taken on loan = Amount repaid in 2 years (-) Interest component = (9262 x 2) - (941+483) = 18524 (-) 1424 = $ 17100
Cash flow statement at actual $ is given below:
Year 0
Year 1
Year 2
Loan taken
17,100
Funding from equity/internal accruals
39,900
Milling machine bought
(57,000)
Operating cash flows
-
19,513
14,641
Loan repayment + Interest
-
(9,262)
(9,262)
Salvage value
-
0
46,408
Net cash flows
-
10,251
51,787
Note: (1) Difference between cost of the machine & loan taken is assumed to be funded through equity/retained earnings in Year 0. (2) Operating cash flows in Year 1 & Year 2 are calculated as Revenue (-) O&M (-) Tax (3) Salvage value of the machine is calculated with an inflation factor of 105.5% as it would be sold at the end of Year 2.
For calculating IRR of the project, above cash flow statement is modified to exclude funding & repayment of loan and is shown below:
Year 0
Year 1
Year 2
Milling machine bought
(57,000)
Operating cash flows
-
19,513
14,641
Salvage value
-
0
46,408
Net cash flows
(57,000)
19,513
61,049
IRR for the above cashflow is working out to 22%.
Constant dollars
Year 1
Year 2
Revenue
37,000
32,000
O&M
13,000
14,300
Depreciation (balancing figure)
8,145
5,980
Operating Income
15,855
11,720
Interest
941
483
Taxable income
14,914
11,237
Tax thereon @ 33%
4,922
3,708
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