Question

Read the following paragraphs and use the information to answer all three multiple questions.

GNK Industries is considering investing in a project. The company has paid a consulting company, Analytics Pty Ltd, $24,000 for analysing the variabilities of the project's future cash flows.

According to the analysis report, the capital expenditure is $2 million and the project will last for 10 years. the project is expected to generate $500,000 EBIT each year. However, customers will reduce their consumption of the company’s existing products because they are going to purchase the new products produced by the project. This annual loss is estimated to be $100,000 after tax. There is no change in the net working capital and the fixed asset will be fully depreciated at the end of year 10 using the straight-line depreciation method. The company will finance this project using its retained earnings and a bank loan at 6% interest rate. The corporate tax rate is 30%.

The company is also discussing the matter with its current solicitor before making a final decision. This leads to an additional consultation fee of $15,000.

What is the total value of the interest tax shield, assuming that the bank loan's principal is $1 million and is permanent?

$300,000

$120,000

$60,000

$180,000

How to classify the cost of generating the analysis report and the solicitor fee?

Opportunity cost; Sunk cost

Sunk cost; Opportunity cost

Sunk cost; Sunk cost

Sunk cost; Incremental cost

What is the free cash flow to the company in year 1?

$450,000

$480,000

$280,000

$250,000

Answer 1

1	Amount of borrowing	1000000
	Interest rate on borrowing	6%
	Interest per year	60000
	Life of the project	10 years
	Interest during life	600000
	Tax rate	30%
	Interest tax shield (30% * 600000)	180000
2	Cost of analysis report is already incurred - Hence, it is sunk cost
	Solicitor fee is to be incurred now if the project needs to be taken up - Hence, it is incremental cost
3	EBIT	500000
	Less: Interest (1 million * 6%)	60000
	Less: Depreciation (2million/10)	200000
	Earnings before tax	240000
	Less: Tax (30%)	72000
	Earnings after tax	168000
	Add: Depreciation	200000
	Free Cash flows	368000