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 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 estima ted 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 invest ment . ( 4 marks)

(b) Calculate the present value of after - tax cash operating income. ( 8 marks)

(c) Calculate the present value of tax savings from depreciation. (4 marks)

(d) Calculate the present value of after - tax salvage value. ( 9 marks)

(e) Based on the net present method, sho uld the project be undertaken? ( 5 marks)

Explanation / Answer

(a).

Intial Investment= 50+10+15+2 = 77 Million

(b)

After Tax Opreating income in first 3 years = 3.75 Milllon

After Tax Opreating income in last 7 years = 7.5 Millon

Using the PV formula in Excel -

PV = $36,758,558.33

(c)

Total Depreciation= Depreciation on Construction + Depreciation on Machinery

= 10 Millon/15+ 15 Millon/10

=0.67+1.5 = 2.17 Millon

Total Savings on tax = 25% of 2.17 millon = 542500

Present Value of Tax Savings= $3,333,427.65

(d) Salvage Value= 1000000

After Tax- 750000

PV of After Tax Salvage Value - 289,157.47

(e)

Based on the NPV , undertaking the project is not revenue generating and would lead to loss . Hence , it is recommended to not undertake and looking for other possible opportunities .

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