Henry Press is considering purchasing a printing machine for £10,000 on 31 December 2021, on the last day of its financial year end. The machine generates cash flows of £7,000 per annum and will be sold for £2,000 on 31 December 2023. The company pays tax at 17% and capital allowances are available at 18% per annum on a reducing balance basis.
The expected returns on the stock market are 12% and the Bank of England base rate is 200 basis points.
Requirements:
Answer :
Required Return = Risk free rate + Beta * ( Return from Market - Risk free rate )
Risk free rate = 2% (200 basis point = 2%)
Expected Return from market = 12%
Beta = 1.5
Required Return = 2% + 1.5 * ( 12% - 2% )
= 2% + 15%
= 17%
Required Return will be used as Discount rate
Calculation of Net Present Value of Printing Machine if company has beta of 1.5
Net Present Value = Present Value of cash Inflow - Present Value of Cash Outflow
| 31-12-2021 | 31-12-2022 | 31-12-2023 | ||
| Initial Investment | 10000 | |||
| Annual Cash Flows | 7000 | 7000 | ||
| Less : Depreciation (Working Note) | 1800 | 1476 | ||
| Earning before taxes | 5200 | 5524 | ||
| Taxes @ 17% | -884 | -939.08 | ||
| Earnings After Taxes | 4316 | 4584.92 | ||
| Add : Depreciation | 1800 | 1476 | ||
| Plus : Salvage Value | 7000 | |||
| Less : tax on salvage @ 17% | 46.92 | |||
| Operating Cash Flows | 10000 | 6116 | 13014 | |
| PV Factor @ 17% | 1 | 0.85470085 | 0.73051355 | |
| PV of Net Cash flows (Inflow) | 5227.35043 | 9506.90335 | ||
| PV of Net Cash flows (Outflow) | 10000 | |||
| The net present value (NPV) of this project is | = $ 4734.25378 or $ 4734.25 | |||
| NPV = PV of cash inflow - PV of cash outflow | ||||
| = 14734.25378- 10000 | ||||
| = $ 4734.25378 or $ 4734.25 | ||||
| Working Note : | ||||
| Calculation of Depreciation | ||||
| Year 1 : 10000 * 18% = 1800 | ||||
| Year 2 : (10000 - 1800) * 18% = 1476 | ||||
| Gain on Sale = Salvage Value - Book Value | ||||
| = 7000 - [10000 - 1800 - 1476] | ||||
| = 7000 - 6724 | ||||
| = 276 | ||||
| Tax on Gain on Sale = 276 * 17% = 46.92 |
If accepting the machine doubles the company’s beta to 3.0, computation of the Net Present Value
Required Return = Risk free rate + Beta * ( Return from Market - Risk free rate )
Risk free rate = 2% (200 basis point = 2%)
Expected Return from Market= 12%
Beta = 3
Required Return = 2% + 3 * ( 12% - 2% )
= 2% + 30%
= 32%
Required Return will be used as Discount rate
Calculation of Net Present Value of Printing Machine
Net Present Value = Present Value of cash Inflow - Present Value of Cash Outflow