Super Technology Company Ltd (STC) produces a range of innovative products for industrial use. As a new product has been developed, STC plans to open a new factory in Shanghai, China. STC uses a seven-year planning horizon for all of its capital budgeting decisions. The following cash flows are noted for the project:
i. The factory will be built on a piece of land near the STC’s existing warehouse and will be purchased at a cost of $20 million and it is expected to be worth $28 million at the end of the project.
ii. STC has already spent $2 million on the development of the new product. If the project is accepted, $500,000 will be spent on the final testing of this product.
iii. The factory will be constructed at a cost of $15 million. The factory will be depreciated at its full cost on a straight line basis over its estimated useful life of 15 years. The factory can be sold at $10 million at the end of the project.
iv. Machinery will be purchased for the factory at a cost of $3.5 million. For tax purpose, machinery will be fully depreciated at its full cost on a straight-line basis over its estimated useful life of seven years. Salvage value of the machinery at the end of the project is $300,000.
v. Equipment will also be purchased at a cost of $1,400,000. Equipment will also be depreciated at its full costs on a straight-line basis over its estimated useful life of seven years. Its salvage value is equal to zero at the end of the project.
vi. An initial investment of $2 million in working capital is required today and an additional $1 million at the end of Year One. The working capital will be fully recovered at the end of the project.
vii. To fund the project, STC has borrowed $20m from the bank and the yearly interest payment is 5%.
viii. Under the new environmental laws and regulations, STC will have to spend $2 million to “clean up” the site at the end of the project.
The management of STC believes that the new product will generate pre-tax cash operating income of $6 million a year in its first three years of operation and $15 million in each of the subsequent four years. STC’s corporate income tax rate is 40% and its cost of capital is 15%. Capital gain tax (10%) is paid when capital gains are realized.
(a) Calculate the initial cost of investment.
(b) Calculate the present value of after-tax cash operating income.
(c) Calculate the present value of tax savings from depreciation.
(d) Calculate the present value of after-tax salvage value.
(e) Based on the net present method, should the project be undertaken?
please list the calculation steps