GROUP ASSIGNMENT

Name Student ID Participation

Đinh Sử Phương Anh 31211025241 100%
Nguyễn Ngọc Phương Anh 31211025196 100%
Nguyễn Quang Duy 31211024714 100%
Lã Tiến Đạt 31211024807 100%
Nguyễn Vũ Thùy Giang 31211025098 100%

SUMMARY
The NMS Milk Joint Stock Company is considering 2 alternative renovation projects:
Repairing the old machinery or Buying new machinery.

We have some basic information:

+ Total book value is $2,400,000 (include the current net book value of the Thanh Cong
plant: $2 million and the net book value of the spare parts inventory: $400,000).

+ If the old plant can be sold on the market along with the spare parts inventory for a
total selling price of $3 million.

+ The renovation will last 1.5 years.

+ Revenue of $15 million will be generated immediately after the renovation. Revenue
will increase along with the inflation rate for the subsequent years.

+ The economic life of machinery is 10 years. The market value upon resale after this
period will be negligible.

+ The inflation rate is 3%.

+ The nominal discount rate is 13%.

+ The corporate income tax rate is 35%.

+ Company uses 7-years MACRS depreciation for initial renovation costs.

+ Operating costs after renovation:

 1. CALCULATING THE NPV OF THE THANH CONG FACTORY
RENOVATION PROJECT

In this exercise, our group uses the nominal cash flows for calculations, then convert them to
real cash flows to find the real NPV.

Calculating process:

 Step 1: Calculating the nominal cash flows of 2 projects, including revenue, operating
cost, depreciation, initial cost and salvage value (if any).

 Step 2: Calculating nominal net cash flows by calculating OCF and then we take into
account the initial cost + salvage value (if any).

 Step 3: Calculating the real NPV including: calculating real discount rate, then we
convert nominal cash flows to real cash flows. Finally, we apply the NPV formula to
find the NPV result of the 2 projects.

First, we calculated the annual operating costs increasing at the inflation rate that the
company paid for both projects.

Next is the total cost for renovating machinery of the first project and purchasing new
machinery for the remaining project, depreciation according to MACRS 8-years for this item.

Then prepare a business status report for both projects, nominal revenue followed by annual
operating costs, machinery purchase costs are considered depreciation items for the next 8
years from the time of operation project. Next, calculate EBT and OCF.

OCF is the nominal cash flow that both projects operate on. This cash flow includes inflation,
so to calculate the real cash flow we discount inflation, and finally discount the cash flow
over the years. from the real discount rate (Fisher formula between inflation rate and nominal
discount rate).

Finally, the sum of the real discounted cash flows for each year gives us the NPV. The
calculation method is the same in both projects.

1.1 CASH FLOWS CALCULATION

● Revenue and Costs

 Cost:
With annual operating costs, this is the total cost that both projects need to spend at the time
the factory goes into operation and increases according to the annual inflation rate (3%).

C n=C n−1 ×(1+3 %)

We can observe that with the project of buying a new machine, operating costs seem to be
lower, which can cause EBT to increase more than that of the renovation project.

Nominal operating cost

Year Renovating the machinery Buying new machinery

0 - -

1.5 $11,200,000 $8,400,000

2.5 $11,536,000 $8,652,000

3.5 $11,882,080 $8,911,560

4.5 $12,238,542 $9,178,907

5.5 $12,605,699 $9,454,274

6.5 $12,983,870 $9,737,902

7.5 $13,373,386 $10,030,039

8.5 $13,774,587 $10,330,940

9.5 $14,187,825 $10,640,869

10.5 $14,613,460 $10,960,095

With renovation costs, this can be considered as the initial cost of both projects. We calculate
the total cost of repairing machinery or buying new ones and start the depreciation cycle at
the time the factory resumes operations. In the second project, purchasing new machinery
cost an additional $8,050,000, higher than the renovation project.

 Revenue:

As for revenue, both projects bring revenue results at the same time, which over the years
will increase with the inflation rate.
 Rn =R n−1 ×(1+3 %)

Nominal revenue

Year Renovating the machinery Buying new machinery

0 - -

1.5 $15,000,000 $15,000,000

2.5 $15,450,000 $15,450,000

3.5 $15,913,500 $15,913,500

4.5 $16,390,905 $16,390,905

5.5 $16,882,632 $16,882,632

6.5 $17,389,111 $17,389,111

7.5 $17,910,784 $17,910,784

8.5 $18,448,108 $18,448,108

9.5 $19,001,551 $19,001,551

10.5 $19,571,598 $19,571,598

● Depreciation
Based on the 7-year MACRS's depreciation calculation, both investment projects in
machinery are depreciated sequentially. The depreciation cost is calculated by taking the total
cost of each project multiplied by the depreciation percentage for each year.

● Salvage value
For both projects, after 10-year economic life, the market value of the machinery is
insignificant so there is no salvage value in the last year. However, in the second project, the
capital gain was recognized at year 0 by selling the old machine. The capital gain on salvage
value after tax is calculated:
Capital gainafter tax=Market value−(Market value−Book value)× Tax rate
Here is the result:
 1.2 NET CASH FLOW CALCULATION

● At first, all the data are at the nominal value (with inflation rate at 3%). So we will calculate
nominal cash flow first, and then we convert to real cash flow later to find the NPV.

Nominal revenue and costs will increase with the inflation rate (at 3%) over years.

● Earning before tax(EBT )=Nominal revenue−Nominal costs−Depreciation

Earning before tax

Year Renovating the machinery Buying new machinery

0 - -

1.5 $2,235,245 $3,884,900

2.5 $1,232,345 $2,144,900

3.5 $2,116,265 $3,678,840

4.5 $2,784,708 $4,838,898

5.5 $3,299,098 $5,731,658

6.5 $3,428,501 $5,956,409

7.5 $3,559,564 $6,184,045

8.5 $4,185,151 $7,269,768

9.5 $4,813,726 $8,360,683

10.5 $4,958,138 $8,611,503

● Taxes expense(at 35 %)=EBT × 35 %

Taxes expense

Year Renovating the machinery Buying new machinery

0 - -

1.5 $782,336 $1,359,715

2.5 $431,321 $750,715

 3.5 $740,693 $1,287,594

4.5 $974,648 $1,693,614

5.5 $1,154,684 $2,006,080

6.5 $1,199,976 $2,084,743

7.5 $1,245,847 $2,164,416

8.5 $1,464,803 $2,544,419

9.5 $1,684,804 $2,926,239

10.5 $1,735,348 $3,014,026

● We calculate the Operating cash flow (OCF) with the Top-down approach method:

OCF=Sales−Costs−Taxes

Operating cash flow

Year Renovating the machinery Buying new machinery

0 - -

1.5 $3,017,664 $5,240,285

2.5 $3,482,679 $6,047,285

3.5 $3,290,727 $5,714,346

4.5 $3,177,715 $5,518,384

5.5 $3,122,249 $5,422,278

6.5 $3,205,266 $5,566,466

7.5 $3,291,551 $5,716,329

8.5 $3,208,718 $5,572,749

9.5 $3,128,922 $5,434,444

10.5 $3,222,790 $5,597,477

● If the company buys new machines, it will recognize capital gain after tax at +$2,790,000.

● Nominal net cash flow is equal to the sum of all the values above

Nominal net CF=∑ (OCF−Initial investment +Capital gainafter tax)

 Nominal net cash flow

Year Renovating the machinery Buying new machinery

0 -$10,950,000 -$16,210,000

1.5 $3,017,664 $5,240,285

2.5 $3,482,679 $6,047,285

3.5 $3,290,727 $5,714,346

4.5 $3,177,715 $5,518,384

5.5 $3,122,249 $5,422,278

6.5 $3,205,266 $5,566,466

7.5 $3,291,551 $5,716,329

8.5 $3,208,718 $5,572,749

9.5 $3,128,922 $5,434,444

10.5 $3,222,790 $5,597,477

1.3 NET PRESENT VALUE CALCULATION

● Real net cash flow is the adjusted nominal net cash flow with the inflation rate at 3%

CF nominal
CF real = t

t
( Inflation+1)t

Real net cash flow

Year Renovating the machinery Buying new machinery

0 -$10,950,000 -$16,210,000

1.5 $2,886,789 $5,013,016

2.5 $3,234,599 $5,616,521

3.5 $2,967,301 $5,152,716

4.5 $2,781,938 $4,831,082

5.5 $2,653,767 $4,608,685

 6.5 $2,644,978 $4,593,435

7.5 $2,637,069 $4,579,711

8.5 $2,495,831 $4,334,640

9.5 $2,362,877 $4,103,944

10.5 $2,362,877 $4,103,944

● When calculating the real cash flow, we use the real discount rate not the nominal rate. We
determine the real discount rate using the Fisher equation.

1+ Nominal discount rate

Real discount rate=( )−1
1+ Inflation rate

We have the result at 9.71%

● Next, we discount real cash flows to present value

FVt
PV = t
(1+r )

then we have Discounted real cash flow:

Discounted real cash flow

Year Renovating the machinery Buying new machinery

0 -$10,950,000 -$16,210,000

1.5 $2,512,194 $4,362,518

2.5 $2,565,768 $4,455,170

3.5 $2,145,445 $3,725,564

4.5 $1,833,420 $3,183,896

5.5 $1,594,175 $2,768,537

6.5 $1,448,286 $2,515,183

7.5 $1,316,171 $2,285,751

8.5 $1,135,442 $1,971,981

9.5 $979,827 $1,701,805

10.5 $893,117 $1,551,203

● Finally, we have the
n
CF t
Net present value=−C o +∑ =∑ Discounted real CF s
t=1 (1+r )t

Net present value

Renovating the machinery Buying new machinery

$5,473,845 $12,311,609

● We do the same calculation for both cases.

Conclusion: The company should buying new machines, since:

NPV buying > NPV renovating ( $ 12,311,609> $ 5,473,845)

2. SIMULATION ANALYSIS

We assume that there are two uncertain variables: inflation rate and discount rate.

● Step 1: Specify the basic model

Annual revenue and annual operating costs change associated with inflation.

Rev n=Rev 0 (1+ Inflation)

cos n=Cost 0 (1+ Inflation)

Discount rate uncertainty has an impact on discounted cash flows:

C Ft
Discounted cash flow= t
(1+r )

● Step 2: Specify a distribution for each variable in the model

In this exercise, we determine that the two variables: inflation rate and discount rate have a
normal distribution, because this type of distribution represents most real events. A highly
likely random value is the median, which will cause the probability to drop significantly
toward both tails of the bell curve.

 The distribution of inflation rate:

  The distribution of discount rate:

● Step 3: The computer draws one outcome

With 1 trial, the computer will pick one scenario by performing drawings for revenue,
operating costs and discounted cash flow. This step generates the cash flow for each year
from a single outcome.
For example: the computer randomly selects the inflation rate at 4%. The probability for the
inflation rate standing at these random values is approximately: 68% ÷ 2 = 34%. So the
probability of this scenario for revenue is: 34%. Additionally, we can perform drawings for
operating costs and discounted cash flow as well. Finally, we get the cash flow for this
scenario.

● Step 4: Repeat the procedure

The computer called on ten thousands of outcomes.

 ● Step 5: Analyzing the results

The NPV of both renovating and buying projects have normal distribution, which reflect the
average of NPV at $5,535,853 and $12,419,300, respectively; with an 100% certainty of
positive NPV. From this distribution, we can do some analysis. For example: We can use this
distribution to estimate the probability of the renovation project getting NPV more than $4
million.
Based on the figure, we can conclude that there is a probability of 92.81% the NPV is greater
than $4 million.

- End -