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You must evaluate a proposal to buy a new milling machine
You must evaluate a proposal to buy a new milling machine. The base price is Rs. 1,08,000, and shipping and installation cost would add another Rs. 12,500. The machine is depreciated under straight line basis. The life of the machine is 4 years. It will be sold after 4 years for Rs. 65,000. The machine would require a Rs. 55,000 increase in working capital. There would be net effect on pre-tax revenues and it will increase by Rs. 44,000 per year (excluding depreciation). The tax rate is 35% and the WACC is 12%. Also, the firm has spent Rs. 5,000 last year investigating the feasibility of using the machine.
a) How would the Rs. 5,000 spent last year be handled?
(b) What is the net cost of the machine for capital budgeting purpose, that is Year 0 project cash flow. Assuming that the machine will be purchased at year 0 and the proposal will start immediately?
c) What are the project's annual cash flows during the year 1,2, 3 and 4?
d) Use the various capital budgeting techniques for the above proposal. Use atleast three techniques and the reason which technique should be used.
e) Should the machine be purchased? Explain your answer with reason as to why the machine should be purchased and why not. If not, suggest measures to make it viable.
Expert Solution
The firm has spent Rs. 5,000 last year investigating the feasibility of using the machine. How would the Rs. 5,000 spent last year be handled?
The amount of Rs. 5000 spent last year is a sunk cost and is irrelevant for the capital budgeting decisions. It should not be considered.
b) What is net cost of machine in the Year 0 (capital outflow) for the project.
| Particulars | Amount in Rs. |
| Purchase cost (Base price) | 1,08,000 |
| Shipping & installation cost | 12,500 |
| Net cost of machine (for Year 0) | 1,20,500 |
c) Project's annual cash flow during Year 1, Year 2, Year3 & Year 4
| Particulars | Rs. | |||
| Pre-tax revenue increase | 44,000 | |||
| Less: Depreciation* | 13,875 | |||
| Profit Before tax | 30,125 | |||
| Less: Tax @35% | 10,543.75 | |||
| Profit After Tax | 19,581 | |||
| Add: Depreciation | 13,875 | |||
| Yearly cash flow | 33,456 | |||
| Particulars | Year 1 | Year 2 | Year 3 | Year 4 |
| Cash flow from Operation | 33,456 | 33,456 | 33,456 | 33,456 |
| Sale of Equipment | 65,000 | |||
| Working capital recoup | 55,000 | |||
| Total Cash flow from project | 33,456 | 33,456 | 33,456 | 153,456 |
* Depreciation = (Cost of Asset - Recovery value)/Life of asset
Depreciation = ((120500-65000)/4
d) Use the various capital budgeting techniques for the above proposal.
Technique 1: Pay back period
To find out the payback period, we need to find out the cumulative cash flow from the project. Below table shows the cumulative cash flow for the project.
| Year | Cash flow | Cumulative cashflow |
| Year 0 | (1,75,500) | (1,75,500) |
| Year 1 | 33,456 | (1,42,044) |
| Year 2 | 33,456 | (1,08,588) |
| Year 3 | 33,456 | (75,131) |
| Year 4 | 1,53,456 | 78,325 |
The cash flow becomes positive after year 3. The pay back period is after 3 years.
Payback = 3 years +(75,131/1,53,456)
Payback = 3 +0.5 = 3.5 years
Payback = 3 years and 6 months
Technique 2 : Internal Rate of Return.
Internal Rate of Retun (IRR) is calculated using excel function (alternatively trail and error method can also be applied).
Below table shows the IRR calculation.
| Year | Cash flow |
| Year 0 | (175,500) |
| Year 1 | 33,456 |
| Year 2 | 33,456 |
| Year 3 | 33,456 |
| Year 4 | 153,456 |
| IRR | 12.5% |
Technique 3 : Net Present Value.
Net Present Value (NPV) is calculated by discounting the cash flows of the project using WACC as the discounting factor.
The below table shows the NPV for the project.
| A | B | C=AxB | |
| Year | DF @ 12% | Cash flow | PV |
| Year 0 | 1.0000 | (175,500) | (175,500) |
| Year 1 | 0.8929 | 33,456 | 29,872 |
| Year 2 | 0.7972 | 33,456 | 26,671 |
| Year 3 | 0.7118 | 33,456 | 23,813 |
| Year 4 | 0.6355 | 153,456 | 97,524 |
| NPV | 2,380 |
Generally, NPV is the preferred Capital Budgeting techniques. Other capital budgeting techinques like Pay back period, IRR, etc have various short comings like -
Payback doesnot consider time value of money while taking the decision and
IRR assumes that the cash flows can be reinvested elsewhere at the internal rate of return, which may not be the case always.
d) Given the positive NPV from the project and the IRR from the machine is slightly higher than the WACC, the machine should be purchased.
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