assignment 4 corporate finance

7/30/2019 Assignment 4 Corporate Finance

1/5

Make Cash Flows

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

Direct Costs 50000 50000 50000 50000 50000 50000 50000 50000

Raw Materials 40000 40000 40000 40000 40000 40000 40000 40000

Total Costs 90000 90000 90000 90000 90000 90000 90000 90000

Tax Deductibility (35%) 31500 31500 31500 31500 31500 31500 31500 31500

Total After Tax Costs 58500 58500 58500 58500 58500 58500 58500 58500

Depreciation 5000 5000 5000 5000 5000 5000 5000 5000

Depreciation Tax Shield 1750 1750 1750 1750 1750 1750 1750 1750

Working Capital Return 0 0 0 0 0 0 0 5000

Total Cash Flow -56750 -56750 -56750 -56750 -56750 -56750 -56750 -51750

Discount Rate 1.20 1.44 1.73 2.07 2.49 2.99 3.58 4.30

Present Value of CF -47291.66 -39409.72 -32841.43 -27367.86 -22806.55 -19005.46 -15837.88 -12035.39

Total Net Present Value -216595.97


2/5

Buy Cash FlowsNow Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

Total Costs 83000 83000 83000 83000 83000 83000 83000 83000

Tax Deductibility (35%) 29050 29050 29050 29050 29050 29050 29050 29050

Total after tax costs 53950 53950 53950 53950 53950 53950 53950 53950

Machinery

Buy New 8000

Sell Old 5000

Book Loss 35000

Tax Saving 12250

Total Machinery CF 9250

Depreciation on New Machinery 2000 2000 2000 2000

Depreciation Tax Shield 700 700 700 700

Excess salary 1000 1000 1000 1000 1000 1000 1000 1000

After Tax cost of salary 650 650 650 650 650 650 650 650

Extra Working Capital

WC returned 5000 12450

WC required 12450

Total Working Capital CF 7450

Total Cash Flow -1800 -53900 -53900 -53900 -53900 -54600 -54600 -54600 -42150

Discount Rate 1.20 1.44 1.73 2.07 2.49 2.99 3.58 4.30

Present Value of Cash Flow -44916.66 -37430.55 -31192.12 -25993.44 -21942.51 -18285.42 -15237.85 -9802.74

Net Present Value of Cash Flow from change in Warehouse Expansion -3807.67

Total NPV -210409.00


3/5

Make Product Cash Flow Explanations

For the Cash Flows and the Net Present Value calculations in the Make product decision

there are 4 major factors that would affect the NPV.

1. Total Costs2. Taxation Rate to calculate Tax deductibility of expenses3. Depreciation4. Working Capital

From the assigned reading it can be clearly understood that the total costs consist of the Direct

Manufacturing Costs and the Raw Materials Cost. This amounts to 90000 every year.

The taxation rate is stated as 35% so after the tax deductibility of expenses we are left with the

after tax expenses as 58500.

To calculate the depreciation tax shield we need to know the yearly depreciation on the machinery

alone. We need not include the building or any other infrastructure, as they would be part of sunk

costs. The yearly depreciation is 5000 as the useful life of the machinery is 8 years and the book

value is given as 40000. After applying the tax rate the tax shield is 1750. Total Cash Flow every

year comes to 56750.

At the end of the project we will need to get the cost of working capital that is 2 weeks of raw

materials and finished products. We do not know the direct cost of the working capital so we will

try to estimate it from the yearly cost of raw materials and finished products. Yearly costs of raw

materials are 40000 and cost of finished products is 90000. Calculating the value of 2 weeks worth

of the same will give us the following

WC of raw materials = 2/52 X 40000

WC of finished product = 2/52 X 90000

Total WC = 2/52 X 130000 = 5000

Using the above information we can find the Net Present Value of the costs of making the product in

house for the next 8 years. We shall discount at a rate of 20% as it is specified as the companys

cutoff rate of return.

We shall arrive at a figure of 216595.97 as the Net Present Value of the cost of the production. The

negative sign indicates that the amount will be an outflow on our part without considering the

margins and the end prices of selling the product.


4/5

Buy Product Cash Flows Explanations

For the Cash Flows and the NPV costing of the in the Buy the production decision is based on

several cash flows.

1. Total Costs2. Excess Salary to be paid3. Change in Working Capital4. Change in Cash Outlay due to early expansion of Warehouse5. Depreciation Tax Shield6. Tax Rate7. New Machinery Costs and Associated Depreciation

The total costs will be reduced to 83000. So calculating the after tax costs of buying we get 53950.

When we buy the production from Amalgamated Components we have to re-assign the chief

operator to a job with an advised salary of 7000 and his current contract states he is to be

compensated 8000 so the extra salary has to be accounted for the project costs and the tax

deductibility has to be done.

We have to maintain a higher inventory/stock than if united metal manufactured so the change in

working capital has to be accounted for so the changes have to be done and reimbursed ant the end

of the project.

The warehouse has to be expanded in the 3rd year rather than in the 4th year we should account for

the change in the net present value due to earlier expenses.

We will need to buy a new machinery costing 8000 that we will have to depreciate in a straight-line

method for 4 yrs.

The book value of the loss in the sale of the machinery should be accounted for and the tax benefitfor the loss should appear on the books. The loss is 35000 so the tax benefit can be calculated as

35% of 35000 that will be 12250.

The Working capital required to maintain an average inventory/stock of 15000 items at the rate of

83 cents per item is 12450.

The difference in the net present value of the warehouse expansion in the 3rd and 4th year has been

calculated as 3807.67

The figure has been calculated by assuming an outflow of 50000 and depreciated over 25 years and

calculating the NPV of the expansion project in the 3rd and the 4th years. Then the NPV in the

current year has been calculated and the difference has been shown in the calculations.


5/5

Arbitration between the Buy or Make decision.

The NPV of both the decisions are almost similar. The difference is slightly above 3% of the entire

NPV. So although both the decisions are equally viable the decision should be based on both the

quality and the companys decision on outsourcing the production.

If the production is outsourced the contract could turn out to be costly in the long run as

Amalgamated Components can dictate the terms of the contract and charge higher prices atrenewal of the contract.

Also if there was a competition between suppliers(Amalgamated Components) then the price could

go down further and hence make the Buy decision much more viable.

assignment 4 corporate finance

Documents