uestion 5 (30 marks Topic 8: Capital Budgetin GoDeep Mining Ltd. (GDM) has just

Question

uestion 5 (30 marks Topic 8: Capital Budgetin 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 for 10 years. The following cash flows are noted for the project i) The production facility will be built on a piece of land near GDM's existing 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 iii) 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 (e) Based on the net present method, should the project be undertaken? (4 marks) (8 marks) (4 marks) (9 marks) (5 marks)

Explanation / Answer

1 Initial Investment - Cost of machine 15000000 Construction Fees 10000000 Increase in Net Working capital - 2000000 27000000 2 Calculation of Annual operating cash flows 1st 3 years Next 7 years Pre tax operating income 5000000 10000000 Interest on loan (5 m x 5%) 250000 250000 EBT 4750000 9750000 Less Tax @ 25% 1187500 2437500 Post tax operating income 3812500 7562500 PV factors 2.4869 3.6577 PV of OPAT 9481123 27661470.56 3 PV of depreciation tax savings Depreciation on construction cost 10000000/15 666666.6667 Depreciation on macchinary 15000000/10 1500000 Total Depreciation 2166666.667 Dep. Tax savings (Dep x tax rate) 541666.6667 PVAF(10%,10 years) 6.1446 PV of depreciation tax savings 3328307.18 3 Post tax salvage value - Salvage value of construction costat the end ofproject = 3000000 Book value 0f machine - Cost - 10000000 Less : Depreciation (cost x 10/15) 6666667 3333333 Loss on sale - -333333 Tax savings - -100000 Post tax salvage value - 3100000 post tax salvage value of machine (1m x 0.7) 700000 Total post tax SV 3800000 PV factor for 10 years 0.385543289 PV Post tax salvage value - 1465064.5 5 NPV - Initial Investments 27000000.00 NWC in Year 2 (1m/1.1^2) -826446.28 NWC in Year 4 (1m/1.1^4) -683013.46 Recovery of NWC (2m+1+1) 4000000.00 PV of OPAT (total of 10 years) 37142593.77 PV of DTS 3328307.18 Post tax salvage value 1465064.50 NPV = 71426505.72 Siince NPV is positive project is viable It is assumed that the land is not sold after project. As nothing is said about the same. Please provide feedback…. Thanks in advance…. :-)

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