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Coursework Assignment – STM December – March 2010

The LSC Corporation is considering investing in a new piece of machinery that will cost
the firm £100,000. It will remain operational for eight years, and will be scrapped at the
end of the eighth year. It will generate annual revenues of £70,000 over that period, and
will incur annual costs of £50,000 over the same period. Its salvage value at the end of
the eight years is £5,000.

The company’s cost of capital is 10 per cent and the firm has a tax rate of 36 per cent

1. Calculate the total present value of the project’s cash flows.


2. How does the capital consumption allowance affect the firm’s cash flows?.
3. Calculate the project’s Net Present Value. Should LSC Corporation invest in this
project?

LSC Corporation Cash Flow Statement

Earnings After CCA for Year


Year Cost Revenues Expenses Tax
0 (100,000)
1 70,000 (50,000) 12,800 10,000
2 70,000 (50,000) 12,800 18,000
3 70,000 (50,000) 12,800 14,400
4 70,000 (50,000) 12,800 11,520
5 70,000 (50,000) 12,800 9,216
6 70,000 (50,000) 12,800 7,373
7 70,000 (50,000) 12,800 5,898
8 70,000 (50,000) 12,800 4,718
Notes: CCA: Capital Consumption Allowance

ANSWERS
1 - Calculating the total present value of the project’s cash flows

A : Cash flows at per term


CCA : Capital Consumption Allowance
v : Tax rate
i : Cost of capital
S : Salvage Value
C : Start-up cost

Total PV without CCA


TPV = C + A1 + A2 + A3 +…+ (An + S)
(1 + i)^1 (1 + i)^2 (1 + i)^3 (1 + i)^n

= -100,000 +(70,000–50,000) + (70,000–50,000) +


(1 + 0.10)^1 (1 + 0.10)^2

(70,000–50,000) + (70,000–50,000) +
(1 + 0.10)^3 (1 + 0.10)^4

(70,000–50,000) + (70,000–50,000) +
(1 + 0.10)^5 (1 + 0.10)^6

(70,000–50,000) + (70,000–50,000 + 5,000)


(1 + 0.10)^7 (1 + 0.10)^8

= £ 9,031.06

Total PV with CCA


TPV = C + A1 + CCA + A2 + CCA1 + A3 + CCA2 + … + (An + S + CCAn)
(1 + i)^1 (1 + i)^2 (1 + i)^3 (1 + i)^n

= -100,000 + (70,000–50,000 + 10.000) + (70,000–50,000 + 18.000) +


(1 + 0.10)^1 (1 + 0.10)^2

(70,000–50,000 + 14.400) + (70,000–50,000 + 11.520) +


(1 + 0.10)^3 (1 + 0.10)^4

(70,000–50,000 + 9.216) + (70,000–50,000 + 7.373) +


(1 + 0.10)^5 (1 + 0.10)^6

(70,000–50,000 + 5.898) + (70,000–50,000 + 5,000 + 4.718)


(1 + 0.10)^7 (1 + 0.10)^8

= £ 66,797.12
2 – Impression of capital consumption allowance on the firm’s cash flows
TPV; CCA olmaksızın hesaplandığında £ 9,031.06 kadar bir nakit akış toplamı
oluştururken, CCA eklendiğinde yaklaşık olarak £ 57,000 ‘luk bir artış göstermektedir.
Böylece firmaya tanınan sermaye kullanım izni, yatırımın getirisini olumlu bir şekilde
etkilemektedir.

3 - Calculating the project’s Net Present Value and LSC Corporation’s preference

NPV without CCA

NPV = C + A1 * (1-v) + A2 * (1-v) + A3 * (1-v) + … + (An + S) * (1-v)


(1 + i)^1 (1 + i)^2 (1 + i)^3 (1 + i)^n

= -100,000 +(70,000–50,000)*(1-0.36) + (70,000–50,000)*(1-0.36) +


(1 + 0.10)^1 (1 + 0.10)^2

(70,000–50,000)*(1-0.36) + (70,000–50,000)*(1-0.36) +
(1 + 0.10)^3 (1 + 0.10)^4

(70,000–50,000)*(1-0.36) + (70,000–50,000)*(1-0.36) +
(1 + 0.10)^5 (1 + 0.10)^6

(70,000–50,000)*(1-0.36) + (70,000–50,000 + 5,000)*(1-0.36)


(1 + 0.10)^7 (1 + 0.10)^8

= - £ 29,380.41

NPV with CCA

NPV = C +(A1 + CCA)*(1-v)+(A2+ CCA)*(1-v)+(A3 + CCA)*(1-v)+…+(An+CCA + S)*(1-v)


(1 + i)^1 (1 + i)^2 (1 + i)^3 (1 + i)^n

= -100,000 +(70,000–50,000)*(1-0.36) + (70,000–50,000)*(1-0.36) +


(1 + 0.10)^1 (1 + 0.10)^2

(70,000–50,000)*(1-0.36) + (70,000–50,000)*(1-0.36) +
(1 + 0.10)^3 (1 + 0.10)^4

(70,000–50,000)*(1-0.36) + (70,000–50,000)*(1-0.36) +
(1 + 0.10)^5 (1 + 0.10)^6

(70,000–50,000)*(1-0.36) + (70,000–50,000 + 5,000)*(1-0.36)


(1 + 0.10)^7 (1 + 0.10)^8

= £ 28,385.65