Capital Investment Appraisal with Working Capital and Financing Effects
Rimu Logistics Ltd is evaluating a $1,200,000 automated sorting system with a five-year life and zero residual value, depreciated straight-line. It expects to save $420,000 per year in labour costs. It will also require an immediate $150,000 investment in spare parts inventory, which is recovered at the end of year 5. Annual maintenance of $60,000 is required from year 2 onward (year 1 is covered by warranty). The company's weighted average cost of capital is 11%, but the project will be 60% debt-funded at 7% pre-tax; the company tax rate is 28%. The CFO proposes discounting at the 7% debt rate because 'that is the cost of the money being used'. The present value annuity factor at 11% for five years is 3.696; at 7% it is 4.100.
1. Critique the CFO's discount rate and calculate the correct after-tax cash flows for years 0, 1 and 5.
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The CFO is wrong on two counts.
First, the discount rate should reflect the risk of the project's cash flows, not the specific source of finance. Financing mix belongs in the cash flows only via the tax shield on interest; it does not change the hurdle rate. Using the 7% debt rate would systematically overstate NPV and accept value-destroying projects.
Second, the 7% is pre-tax. Even if a debt-based rate were conceptually defensible, it would need to be after tax: 7% × (1 − 0.28) = 5.04%. The correct rate here is the 11% WACC.
Cash flows:
- Year 0: equipment −$1,200,000; working capital −$150,000 → −$1,350,000
- Year 1: labour saving $420,000; maintenance $0; tax: taxable income = 420,000 − depreciation 240,000 = 180,000; tax at 28% = $50,400. After-tax cash flow = 420,000 − 50,400 = $369,600. (Equivalently 420,000 × 0.72 + 240,000 × 0.28.)
- Year 5: labour saving $420,000 − maintenance $60,000 = $360,000; taxable = 360,000 − 240,000 = 120,000; tax = $33,600; after-tax operating = $326,400; plus working capital recovery $150,000 → $476,400.
The examiner's target is whether you can separate investment appraisal from financing, and whether you correctly handle depreciation as a non-cash tax shield rather than a cash outflow.
2. Compute the NPV using the 11% factors and advise whether the project should proceed, noting one qualitative factor.
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Annual after-tax operating cash flows:
- Year 1: $369,600
- Years 2–4: 360,000 × 0.72 + 240,000 × 0.28 = 259,200 + 67,200 = $326,400 each
- Year 5: $326,400 + $150,000 working capital = $476,400
Discounting at 11%:
- Year 1: 369,600 × 0.9009 = $333,000 (approx.)
- Years 2–4: 326,400 × (3.696 − 0.9009 − 0.5935) = 326,400 × 2.2016 ≈ $718,600
- Year 5: 476,400 × 0.5935 ≈ $282,700
- Total PV of inflows ≈ $1,334,300
- Less year 0 outflow $1,350,000
- NPV ≈ −$15,700
A small negative NPV. On a strict financial criterion, reject - but the margin is thin relative to the $1.35m outlay (about 1%), so it is sensitive to assumptions. If maintenance were $50,000 rather than $60,000, the project would turn positive. The recommendation should be to reject as presented but re-test key assumptions - particularly the labour saving, which is the dominant driver.
Qualitative factor: the labour saving may be achievable only by headcount reduction, which carries redundancy costs, industrial-relations risk and reputational damage not captured in the cash flows. Alternatively, automation may deliver reliability and safety benefits that are hard to monetise but real. Either way, the decision is not purely arithmetic.