Oklahoma City Corporation is planning to sell a new mineral that it can extract
ID: 2785837 • Letter: O
Question
Oklahoma City Corporation is planning to sell a new mineral that it can extract in addition to its normal product line. This requires new equipment costing $600,000 and will be depreciated over 5 years for tax purposes in the following manner: Year 1 , 20%; Year 2, 32%; Year 3, 16%, Year 4, 16%; and Year 5, 1 69 . The company will assume no salvage value in computing the depreciation. In addition, in order to finance the additional sales and inventory from the new mineral, the company will have to invest an additional $100,000 in working capital at the beginning of the project, which will be returned for general operating use at the end of the five years. In addition, when the project is over, the company can sell the used equipment for $25,000 to another company that has a use for such equipment. The expected additional cash revenues and cash expenses in current dollars, to be earned and incurred evenly throughout each year, from sale of the new mineral are shown below. OKLAHOMA CITY CORPORATION BUDGETED CASH REVENUES AND CASH EXPENSES FOR CAPITAL INVESTMENT IN EQUIPMENT Year Cash Revenues Cash Expenses 500,000S 575,000 630,000 680,000 600,000 300,000 400,000 500,000 555,000 480,000 4 The company desires an after tax rate of return, unadjusted for inflation, of 10%. Inflation is expected to average 3% per year over the life of the equipment. The company also desires all projects to pay back their investment in 4 years or less on an after tax basis. The company's average tax rate is 30%.Explanation / Answer
(1) To calculate the accounting rate of return, let's construct the below table showing the accounting profit/(loss) for the 5 years after tax:
Year
Revenues
Expenses
Inflation factor @ 3%
Inflation adjusted revenue
Inflation adjusted exp
Operating income before depcn
Depreciation
Accounting profit
Accounting profit after tax
1
500,000
300,000
1.03
515,000
309,000
206,000
120,000
86,000
60,200
2
575,000
400,000
1.06
610,018
424,360
185,658
192,000
(6,343)
(4,440)
3
630,000
500,000
1.09
688,418
546,364
142,055
96,000
46,055
32,238
4
680,000
555,000
1.13
765,346
624,657
140,689
96,000
44,689
31,282
5
625,000
480,000
1.16
724,546
556,452
168,095
96,000
72,095
50,466
Total
169,747
Average per year
33,949
Note:
a) In year 5, revenues include scrap sale value of equipment of $25,000 which also has been assumed to get adjusted for inflation.
b) Depreciation has been calculated at original cost of equipment x tax depreciation rates for various years as given in the question
Accounting rate of return = Average profit per year after tax/ Average investment = 33949/(600000+100000)= 33949/700000 = 4.8%
The accounting rate of return of 4.8% of the proposal is way below the the company's desired rate of return of 10% & hence, the proposal is not worth pursuing.
(2),(3) & (4) To compute the discounted payback period, NPV and Profitability Index, we need to compute the discounted cash flows as below:
Year
Investment [A]
Inflation adjusted Operating income before depcn [B]
Tax @ 30% on B [C]
Tax savings on depreciation [D]
Net Cash Flows E= [A+B+C+D]
Discount factor @ 10% [F]
Discounted cash flows [E x F]
0
(700,000)
(700,000)
1.00
(700,000)
1
206,000
(61,800)
36,000
180,200
0.91
163,818
2
185,658
(55,697)
57,600
187,560
0.83
155,008
3
142,055
(42,616)
28,800
128,238
0.75
96,347
4
140,689
(42,207)
28,800
127,282
0.68
86,935
5
100,000
168,095
(50,428)
28,800
246,466
0.62
153,036
Total (NPV)
(44,855)
Note: Inflation adjusted operating income before depreciation in this table is the same as Operating income before depreciation we computed in the earlier table.
As seen from the above table, sum of discounted cash flows from years 1 to 5 is $ 655145 which is less than initial cash outflow of $ 700000 & therefore the discounted pay-back period of the proposal is beyond the proposal life of 5 years. In other words, the discounted cash flows of the proposal over the life of 5 years do not recover the initial investment.
NPV of the project @ 10% discount rate is -44,855. Since it is negative, the proposal is not worth investing.
Profitability Index (PI) = PV of cash inflows/Initial investment = 655145/700000 = 0.936. Since it is less than 1, PI also shows that the proposal does not generate enough cash flows to recover the initial investment & therefore is not worth investing.
Year
Revenues
Expenses
Inflation factor @ 3%
Inflation adjusted revenue
Inflation adjusted exp
Operating income before depcn
Depreciation
Accounting profit
Accounting profit after tax
1
500,000
300,000
1.03
515,000
309,000
206,000
120,000
86,000
60,200
2
575,000
400,000
1.06
610,018
424,360
185,658
192,000
(6,343)
(4,440)
3
630,000
500,000
1.09
688,418
546,364
142,055
96,000
46,055
32,238
4
680,000
555,000
1.13
765,346
624,657
140,689
96,000
44,689
31,282
5
625,000
480,000
1.16
724,546
556,452
168,095
96,000
72,095
50,466
Total
169,747
Average per year
33,949
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