This question relates to capital budgeting. Farming Services Ltd is considering the purchase in January, 2019 of three new tractors costing $300,000 each, which it will fully finance with a fixed interest loan of 8% per annum, with interest paid monthly and the principal repaid at the end of 4 years. The tractors will be used in the company’s rural services business.
The three new tractors will replace four existing smaller tractors enabling the company to increase sales and to reduce its labour, etc. costs by a net total of $175,000 each year, over the next 4 years. [Assume these benefits are realized at the end of each year.]
The new tractors may be depreciated for tax purposes by the straight-line method to zero over the next 4 years. The company thinks that it can sell the tractors at the end of 4 years for $50,000 each.
The four old tractors being replaced were bought three years ago for $210,000 each, with a then life expectancy of 7 years, and are being depreciated by the straight line method to zero over 7 years. If the company proceeds with the above purchase, the old tractors will be sold in January, 2019 for $100,000 each.
This is not the first time that the company has considered this purchase. Twelve months ago, the company engaged Agrarian Consultants, at a fee of $20,000 paid in advance, to conduct a feasibility study on savings strategies and Agrarian made the above recommendations. At the time, Farming Services Ltd did not proceed with the recommended strategy, but is now reconsidering the proposal. I
f the changeover proceeds, Farming Services Ltd further estimates that it will have to spend $20,000 in 2 years’ time and $30,000 in 3 years’ time overhauling the tractors. It will also require additions to current assets of $20,000 at the start of the new tractors project, which will be fully recoverable at the end of the fourth year after purchase. Farming Services Ltd’s cost of capital is 10%. The tax rate is 30%. Tax is paid in the year in which earnings are received.
REQUIRED: (a) Calculate the net present value (NPV), that is, the net benefit or net loss in present value terms, of the proposed purchase costs and the resultant incremental cash flows.
[HINT: It is recommended that for each year you calculate the tax effect first, then identify the cash flows, then calculate the overall net present value. Finally, make your recommendation.]
(b) Should the company purchase the new tractors? State clearly why or why not.