GoDeep Mining Ltd. (GDM) has just finished a marketing study and concluded that

Question

GoDeep Mining Ltd. (GDM) has just finished a marketing study and concluded that capacity expansion will lead to significant increase in sales. The production facility to be built is expected to last t for 10 years. The following cash flows are noted for the project: existing i) The production facility will be built on a piece of land near GDMs manufacturing facility. The land has just been purchased at a cost of $50 million and is expected to be worth $100 million at the end of the project. ii) The construction fee for the production facility is estimated to be of $10 million. The facility will be depreciated at its full cost on a straight line basis over its estimated useful life of 15 years and is to be sold at $3 million at the end of the project. ii) Machinery will have to be purchased for the factory at a cost of $15 million. For tax purpose, machinery will be fully depreciated at its full cost on a straight-line basis over its estimated life of 10 years. Salvage value of $1 million is expected. iv) An initial investment of $2 million in working capital is required today and another $3 million at the end of Year Two and Year Four, respectively. The working capital will be fully recovered at the end of the project. v) To fund the project, GDM has borrowed $20m from the bank and the yearly interest payment is 5%. The management of GDM estimates that the new factory will generate yearly pre-tax cash operating income of $5 million in its first three years of operation and $10 million in the remaining seven years. GDM's corporate income tax rate is 25% and its cost of capital is 10% Capital gain tax is 30% which is paid when it is realized. (a) Calculate the initial cost of investment. (b) Calculate the present value of after-tax cash operating income. (c) Calculate the present value of tax savings from depreciation. (d) Calculate the present value of after-tax salvage value. (4 marks) (8 marks) (4 marks) (9 marks) (5 marks) (e) Based on the net present method, should the project be undertaken?

Explanation / Answer

1. Calculation of initial cost of investment : Particulars Amount ( in. Million $) a) Purchase of land for production facility 50 b) Construction fee for production facility 10 c) Purchase of machinery for the factory 15 d) Working Capital 2 Initial Cost of Investment 77 2. Caluculation of present value of after tax cash operating income : years Particulars 0 1 2 3 4 5 6 7 8 9 10 ( in.Million$) (in.Million$) (in.Million$) (in.Million$) (in.Million$) (in.Million$) (in.Million$) (in.Million$) (in.Million$) ( in.Million$) ( in.Million$) Investment -75 Working Capital -2 -3 -3 Operating income 5.00 5.00 5.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 total cash flow -77 5.00 2.00 5.00 7.00 10.00 10.00 10.00 10.00 10.00 10.00 Less : Depreciation 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 (wn-1) EBIT 2.93 -0.07 2.93 4.93 7.93 7.93 7.93 7.93 7.93 7.93 Less: Interest 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 (20million* 5%) EBT 1.93 -1.07 1.93 3.93 6.93 6.93 6.93 6.93 6.93 6.93 Less : Tax @ 25% 0.48 0.00 0.48 0.98 1.73 1.73 1.73 1.73 1.73 1.73 EAT 1.45 -1.07 1.45 2.95 5.20 5.20 5.20 5.20 5.20 5.20 Add : Depreciation 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 2.07 Cash operating income 3.52 1.00 3.52 5.02 7.27 7.27 7.27 7.27 7.27 7.27 Add: Salvage Value of Machinery 1.00         Land 100.00 Resale of construction 3.00 Tax benefit from capital loss * 0.09 Add : working capital recoevry 3.00 3.00 Net Cash Flow -77 3.52 4.00 3.52 8.02 7.27 7.27 7.27 7.27 7.27 111.36 discount value at 10% 1 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 present value -77 3.20 3.30 2.64 5.48 4.51 4.10 3.73 3.39 3.08 42.98 Net Present value of net cash operating income -0.58        * The capital loss arises because the resale value ($3 millon) is less than the net book value ($3.3million).           The tax benefit from the capital loss is computed by multiplying the amount of the capital loss by the            tax rate ($0.09 = 0.30 * $0.3). This represents the tax shield, i.e. the reduction in taxes from the capital loss.            Working Note : 1.     Caluculation of depreciation : 1. Construction cost $10 million estimated useful life is 15 Years salvage value is =0 depreciation = $10 million /15 years 0.67 2. Value of Machinery is $ 15 million estimated useful life is 10 Years salvage value is $1 million depreciation = ($15 million -$1million )/10 years 1.4 Total Depreciation 2.07 3. Calculation of present value of tax saving from depreciation :- ( in.Million$) Total Depreciation per year (Wn-1) 2.07 Tax Saving from Depreciation = 1.87 * 25 % 0.52 Present value for 10 years at discounted rate 10% 6.144 Present value of tax saving from depreciation = 0.47 *6.144 3.18 4. Calculation of present value of after tax salvage value :- ( in.Million$) Salvage Value Land 100 construction plant 3 machinery 1 Total Salvage value 104 Less : Tax @30% 31.2 After Tax salvage value 72.8 Disc. Pv on 10th year @10%   = 0.386 Present value of after tax salvage value 28.10 5 Based on net present value the project gives NPV in Negative Value so the project is not acceptable.

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