Capital Budgeting

Question:
Vita Health is thinking of introducing a new health product for its expansion
program. In order to manufacture the new product, the company needs to
buy a new processing machine costing RM1 million, plus RM60,000 for
modification and RM40,000 for shipping and installation. The company is also
required to increase its inventory level by RM50,000 and accounts payable is
expected to increased by RM20,000. The machine is expected to have a
useful life of 8 years, with salvage value of RM100,000. The company uses
the straight-line method in depreciating its non-current assets.
It is expected that the machine will need major repairs in year 5. The cost of
the repairs is estimated to be RM80,000. Since it involves a large cash flow,
the company is deciding to capitalize the expenditure and to depreciate it
over its remaining useful life.
The company has spent RM30,000 on a survey carried out last year to study
the market response to the new product. Based on the survey, the company
expects to sell 45,000 bottles at RM10 each for the first 5 years and 50,000
bottles at RM13 each for the subsequent years. The production costs are
estimated to be 50% of the selling price.
The corporate tax rate is 25% and its cost of capital is 15%.
Required:
a.

b.

c.

Determine the following:

i.
The initial outlay
ii.
The annual differential cash flows
iii.
The terminal cash flows
Calculate the projects
i.
Payback period
ii.
Net present value
iii.
Internal rate of return
Would you accept the project?

Solution:
Outflows:New processing machine
+ Modification Fees
+ Shipping and installation fees
+ Increased inventory level
- Increased account payable
Expected:-

RM1 Million
RM60,000
RM40,000
RM50,000
(RM20,000)

Useful life 8 years.

Salvage Value RM100,000.
Major repair in year 5. Cost repair RM80,000

Production:Expected to sell 45,000 bottles x RM10 (1 5 years)

Expected to sell 50,000 bottles x RM13 x (6 8 years)
Production cost is 50% from selling price
Others:Corporate tax rate 25% Cost of capital 15%
A i) The Initial Outlay
Cash Outflows:
Purchase Price
+ Modification Fees
+ Shipping and installation

RM
1,000,00
0
60,0
00
40,000

fees
Installed cost of machine
Working Capital:
+
Increased
inventory
level
- Increased account payable
Initial Outlay

1,100,00
0
50,000
(20,000)
1,130,0
00

A ii) The annual differential cash flows

Depreciation expense on new machine using straight line method:
Cost of the new machine (as per initial outlay) = RM1,100,000
Salvage Value = RM100,000
Useful life = 8 years
Depreciation per year = RM1,100,000 RM100,000
8
= RM125,000
Annual differential cash flow:
Year 1
4
(RM)

Year 5
(RM)

Year 6
8
(RM)

450,000

450,000

650,000

(225,00

(225,00

(325,00

Repair Cost
Depreciation

0)
(125,00

0)
(80,000)
(125,00

0)
(125,00

Net Profit Before Tax

- Taxation (25%)
Net Profit After Tax (EAT)
+ Depreciation Reversal
Annual after-tax differential

0)
100,000
(25,000)
75,000
125,000
200,000

0)
20,000
(5,000)
15,000
125,000
140,000

0)
200,000
(50,000)
150,000
125,000
275,000

Benefit:
Sales
(45,000 bottles x RM10)
- Costs:
Production cost
(50% from selling price)

cash flows
A (iii) Terminal cash flows
Salvage Value of new machine
= RM100,000
+ Net Working Capital
= RM30,000.
Terminal cash flows
= RM130,000

B (i) Payback Period

Initial Outlay

= RM1,130,000.00

Yea
r

Annual after tax CF

(RM)

0
1
2
3
4
5
6
7
8

(1,130,000)
200,000
200,000
200,000
200,000
140,000
275,000
275,000
275,000

Accumulate
d CF
(RM)
200,000
400,000
600,000
800,000
940,000

Payback Period

= T + IO ACFT
ACF T+1
= 5 + (RM1,130,000 RM940,000)
275,000
= 5.69 years

B (ii) Net Present Value (NPV)

Year (T)
1
2
3
4
5
6
7
8

ACF
(RM)
200,000
200,000
200,000
200,000
140,000
275,000
275,000
275,000

PVIF 15%, 8
(RM)
0.8696
0.7561
0.6575
0.5718
0.4972
0.4323
0.3759
0.3269
Total
- IO
NPV

PV
(RM)
173,920
151,220
131,500
114,360
69,608
118,882.50
103,372.50
89,897.50
952,760.50
(1,130,000.00)
-RM177,239.50

C (iii) Internal Rate of Return

Year (T)
1
2
3
4
5
6
7
8

Year (T)
1
2
3
4
5
6
7
8

ACF
(RM)
200,000
200,000
200,000
200,000
140,000
275,000
275,000
275,000

PVIF 10%, 8
(RM)
0.9091
0.8264
0.7513
0.6830
0.6209
0.5645
0.5132
0.4665
Total
- IO
NPV

PV
(RM)
181,820
165,280
150,260
136,600
86,926
155,237.50
141,130
128,287.5
1,145,541
1,130,000
RM15,541

ACF
(RM)
200,000
200,000
200,000
200,000
140,000
275,000
275,000
275,000

PVIF 11%, 8
(RM)
0.9009
0.8116
0.7312
0.6587
0.5935
0.5346
0.4817
0.4339
Total
- IO
NPV

PV
(RM)
180,180
162,320
146,240
131,740
83,090
147,015
132,467.50
119,322.50
1,102,375
1,130,000
-RM27,625

r= 15,541
r= 10%
15,541

NPV = 0
0
R= 43,166

IRR

= 10% + 15,541 (11%-10%

43,166
= 10% + 3.60%
= 13.60%

c) Reject the project because its net present value is negative (RM177,239.50) and internal rate of return is lower than 15%

R=11%
-27,625