EXERCISE (CASH FLOWS IN CAPITAL BUDGETING)

1. LR Industries is considering the purchase of a new piece of equipment to meet the

increased demand for its Model XL-4 tennis racket. The equipment costs $100,000 plus
$5,000 for installation and shipping, the resulting increased production is expected to
require additional NWC of $25,000.
a) What is the net investment that LR Industries will make on the new equipment?
b) The new equipment that LR industries will purchase would be depreciated using
simplified straight-line method and is considered 10-year expected life. The
equipment is expected to enable the firm expand sales by $80,000 per year
with an increase in cash operating expenses amounting to 60% of the increase
in sales. The firm’s marginal tax rate is 34%. What is the annual operating cash
flows for the first three years?
c) LR Industries estimates that the equipment’s salvage value will be $10,000 at
the end of its 10-year life. The company expects to release its $25,000 in
additional NWC. If the firm’s marginal tax rate is 34%, what is the terminal cash
flow?

2. Pedas Bhd. is company that involves in the production of chili sauce under the brand
name of PODEH! The company plans to buy a new chili-grinding machine that costs
RM240,000 for the purpose of increasing its current production capacity. Delivery and
installation costs of the machine are Rm500 and RM1,500 respectively while the
training costs for the use of the machine is RM800.

The new machine will be able to increase annual sales by RM50,000 and at the same
time be able to save production costs by RM5,000 per year. The machine has a useful
life of 5 years and its depreciated using a simplified straight-line method. Pedas Bhd.
expects that the machine can be sold as scrap metal at the end of its useful life for
RM5,000.

The maintenance and repair costs for the machine is RM2,200 per year. In addition, the
purchase of the machine will also result in an additional net working capital of
RM5,000 and is expected to stay the same every year until the end of the project. The
tax rate is 28% while the required rate of return is 14%.

a) Calculate the initial outlay of the project.

b) Calculate the annual cash flows from year 1 until year 4.
c) Calculate the terminal value of the project in year 5. What is the cash flow in
year 5.
d) Calculate the NPV of the project. Should the company go ahead with the plan?
3. BARA Corporation, a leading men’s leather shoe manufacturer in Malaysia has been
operating for more than 40 years. Due to new demands and increasing competition,
the company is contemplating to add its product line by manufacturing women’s
leather shoes. This project requires a big capital because of the difference in the
 production and marketing of men’s and women’s shoes. The company needs to expand
its factory and renovate its stores. The expected costs are as follows:

Asset items Costs (RM)

Costs of new processing machine (useful life = 5 750,000
years and depreciated using simplified straight
line method)
Land 360,000
Building 520,000
Expense items
Recruitment and training 120,000
Initial marketing and promotion expenses 150,000
Annual marketing and promotion expenses 50,000
Annual salary 600,000
Annual overhead 2,800
Working capital
Inventory 360,000
Accounts payable 240,000
Accounts receivable 203,125

Sales: 25,000 units of women’s shoes are expected to be sold every year at an average
price of RM65.00 per unit.

At the end of year 5, the processing machine is expected to be sold at a price of

RM140,000. Tax rate is 28% and cost of capital is 10%. Should the company go ahead
with the plan?

4. En. Talib, a financial officer at Kanvas Corporation Sdn. Bhd. has been instructed by his
CEO to re-check the tender a tender bid draft for a contract to supply canvas to
Angkatan Tentera Malaysia (ATM). The tender requires that the company supplies
100,000 meters of canvas every year for a period of 5 years. The price for a meter of
canvas is RM30.

If the company succeeds in getting the tender, Kanvas Corporation needs a new
machine at a cost of RM1 million. The new machine will be depreciated using a
simplified straight-line method for 5 years, and the company expects that the machine
can be sold to a used machine broker at the end of the project period for RM250,000.
In addition, the company also needs to renovate its old factory for the purpose of
canvas processing at a cost of RM500,000. The factory depreciates on a simplified
straight-line method for 5 years. En. Talib also receives an additional information from
his CEO that a hotel chain company offered RM600,000 to purchase the old factory
inclusive of its land.
 On operations and sales, Kanvas Corporation will incur fixed costs amounting to
RM300,000 per year, and also variable costs of RM18 for each meter of canvas
produced. The initial net working capital required is RM300,000 and the annual
working capital requirement is expected to stay at the same level. The tax rate is 25%,
while the required rate of return is 12%. Calculate the NPV of the project and should
the company go ahead with the plan?

5. Mizan Bhd is analyzing a new project that involves a new product called ZPX-1. The
project is expected to last for 5 years. The cost of factory and new equipment is RM10
million and the transportation and installation costs are RM120,000. The useful life of
the assets is 10 years. The assets are expected to be sold at the end of the project for
RM5 million.

The company will produce 100,000 units of ZPX-1 every year and will sell them at RM30
per unit. This price will be constant throughout the 5-year period. The variable cost for
the product is RM13 per unit, while the fixed costs are RM250,000 per year. The
requirement for the net working capital at the beginning of the project is RM150,000
and this annual requirement is expected to stay constant throughout the 5-year period.
The simplified straight-line method is used, cost of capital is 15%, while the tax rate is
34%. Calculate the NPV and should the company accept the project?

6. Raymobile Motors is considering the purchase of a new production machine for

$500,000. The purchase of this machine will result in an increase in EBIT of $150,000
per year. To operate the machine properly, workers would have to go through a brief
training session that would cost $25,000 after tax. In addition, it would cost $5,000
after tax to install the machine properly. Also, because the machine is extremely
efficient, its purchase would necessitates an inventory of $30,000. This machine has an
expected life of 10 years, after which it will have no salvage value. Assume simplified
straight line depreciation and that the machine is being depreciated to zero, a 34%
marginal tax rate, and a required rate of return of 15%.

a) What is the initial outlay associated with this project?

b) What are the annual after-tax cash flows associated with this project for
years 1 through 9?
c) What is the terminal cash flow in year 10?
d) Should the machine be purchased?