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1. Sales- The question said sales increased by 9000 per year so shouldn’t we increase it by 9000 year on year? And if I messed up this part would the own figure rule apply for the rest below?
2.WC-Wouldn’t inflation increase the requirement year on year therefore we would +/- any increase or decrease in requirement? The answer basically just inflated the difference year on year. And since it continues beyond T4 shouldn’t it be in T5 as well like tax?
3. They said it was being replaced after 4 years so shouldn’t we -5000 in T4?
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For no.1- there is a similar wording in the technical article as well on advanced IA where they say sales will fall by 5000 per year and it was year on year.
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ADM Co is a listed company which plans to meet increased demand for its products by buying new machinery costing $5 million. The machinery would last for four years, at the end of which it would be replaced. The scrap value of the machinery is expected to be 5% of the initial cost. Capital allowances would be available on the cost of the machinery on a 25% reducing balance basis, with a balancing allowance or charge claimed in the final year of operation.
This investment will increase production capacity by 9,000 units per year and all of these units are expected to be sold as they are produced. Relevant financial information in current price terms is as follows:
Forecast inflation
Selling price
$650 per unit
4·0% per year
Variable cost
$250 per unit
5·5% per year
Incremental fixed costs
$250,000 per year
5·0% per year
In addition to the initial cost of the new machinery, initial investment in working capital of $500,000 will be required. Investment in working capital will be subject to the general rate of inflation, which is expected to be 4·7% per year. Working capital will not be released at the end of the 4 years.
ADM Co pays tax on profits at the rate of 20% per year, one year in arrears. The company has a real after-tax cost of capital of 7% per year and a nominal after-tax cost of capital of 12% per year.
1. The question says that the capacity will increase by 9,000 a year, but that does not mean an extra 9,000 in each of the years. How could that happen? The new machine is increasing the capacity but how could it keep increasing the capacity even more in future years?
The own figure rule would apply to further parts of the question as also if you messed it up.2. The initial working capital is $500,000. In a years time they will need it to be 500,000 x 1.047, but since they already have 500,000 all they will need as an outflow is the extra to take 500,000 up to the total required (and similarly in each future year).
There is no reason whatsoever from the question for any flow after the 4 years.3. I am assuming you mean the $5M initial cost. If so, then no you would not bring it in. We are only appraising this one machine. At the end of the 4 years they would then appraise the new machine in a similar way (and the cost would probably no longer be $5M anyway 🙂 )
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1. So suppose the question says the sales are currently at 200000 and then says the new machine would increase sales by 10000 per year. Would we take only 10000 or 210000 in the NPV calculations?
2. Yup, that is exactly what I did and got -500,-24,-50,-85,-133 respectively I calculate the requirement each year and minus off the difference from previous yr. But the answer basically took -24 and inflated it to -25 to -26 and so on.
1. 10,000
2. At time 0 it is 500. At time 1 they need an extra 4.7% of 500 which is 24. So they now have 524. At time 2 they need an extra 4.7% of 524 which is 25. So they now have a total of 549. At time 3 the need an extra 4.7% of 549 which is 26. And so on.
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Ok that makes sense! 3 final question on this
1. If T3 is for the fourth year and the machine lasts only 4 years. So why do we even include T4 then as that is working capital for year 5?2. If they said WC is based of 10% sales but didn’t specifically say WC is inflating, do we take the uninflated sales for WC requirement or do the inflated sales?
3. If the investment has TAD of straight line over 10 years but has an assumed terminal value of 2000 after 4 years, would there be a balancing figure?
1. Usually at time 4 we would get back all the working capital (and you would get full marks if you did that). However the reason we have not got it back but have had another outflow is because working capital will still be needed (because the machine will be replaced and production will continue).
2. Yes there would.
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Alright, thank you so much Sir!
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