(a) The initial investment in year 0 will include the cost of the new machine and the initial net working capital. Therefore, the initial investment will be K10,000 + K1,000 = K11,000.
(b) To calculate the post-tax operating cash flows in years 1 to 3, we need to first calculate the earnings before taxes (EBT) and then subtract taxes.
Year 1:
EBT = EBDIT - Depreciation
= K4,000 - (K10,000/3)
= K4,000 - K3,333.33
= K666.67
Taxes = EBT * Tax Rate
= K666.67 * 40%
= K266.67
Post-tax Operating Cash Flow = EBT - Taxes
= K666.67 - K266.67
= K400
Year 2:
EBT = EBDIT - Depreciation
= K5,000 - (K10,000/3)
= K5,000 - K3,333.33
= K1,666.67
Taxes = EBT * Tax Rate
= K1,666.67 * 40%
= K666.67
Post-tax Operating Cash Flow = EBT - Taxes
= K1,666.67 - K666.67
= K1,000
Year 3:
EBT = EBDIT - Depreciation
= K6,000 - (K10,000/3)
= K6,000 - K3,333.33
= K2,666.67
Taxes = EBT * Tax Rate
= K2,666.67 * 40%
= K1,066.67
Post-tax Operating Cash Flow = EBT - Taxes
= K2,666.67 - K1,066.67
= K1,600
(c) The non-operating cash flow in year 3 will be the sale of the machine at K5,000.
(d) To decide if the project should be undertaken or not, we will use the Average Accounting Return (AAR), Net Present Value (NPV), and Payback Period (PP) methods.
Average Accounting Return (AAR):
AAR = Average Annual Earnings / Initial Investment
= (EBIT1 + EBIT2 + EBIT3) / 3 / K11,000
= (K666.67 + K1,666.67 + K2,666.67) / 3 / K11,000
= K4,000 / K11,000
= 0.3636 or 36.36%
Net Present Value (NPV):
Discount rate = 10%
NPV = (Post-tax Operating Cash Flow1 / (1+Discount rate)^1) + (Post-tax Operating Cash Flow2 / (1+Discount rate)^2) + (Post-tax Operating Cash Flow3 + Non-operating Cash Flow3) / (1+Discount rate)^3 - Initial Investment
= (K400 / 1.1^1) + (K1,000 / 1.1^2) + (K1,600 + K5,000) / 1.1^3 - K11,000
= (K400 / 1.1) + (K1,000 / 1.21) + (K6,600) / 1.331 - K11,000
= K363.64 + K826.45 + K4,956.24 - K11,000
= K5,146.33 - K11,000
= -K5,853.67
Profitability Index (Pl):
PI = NPV / Initial Investment
= -K5,853.67 / K11,000
= -0.5322 or -53.22%
Based on the AAR, NPV, and Pl methods, the project should not be undertaken as the AAR is 36.36%, NPV is negative at -K5,853.67, and Pl is negative at -53.22%.
Your firm is considering investing in a project, the details of which are given below: A new machine costing K10,000 is required. The project also requires an initial net working capital of K1,000, which will be recovered at the end of the project life (year 3) The new machine is being depreciated using the straight-line method to a zero salvage value. The new machine can be sold at the end of the project (end of year 3) for K5,000. The project will generate earnings before depreciation, interest, and taxes (EBDIT) of K4,000 in year 1, K5,000 in year 2 and K6,000 in year 3. The firm's tax rate is 40% (a) What will be the initial investment in year 0? (3 marks) (b) What are the post-tax operating cash flows in years 1 to 3? (9 marks) (c) What is the non-operating cash flow in year 3? (3 marks) (d) Use the AAR, NPV and Pl methods to decide if the project should be undertaken or not. Use 10% as the discount rate where needed. (12
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