Capital Budgeting Analysis

Questions: Harry Hill is considering replacing an old machine with a new one from Li Xu because one year ago a feasibility study on the new machine conducted for Harry by PQ Ltd, an external firm of consultants, costing Harry $20,000, concluded in favour of buying this new machine. The old machine (bought 5 years ago from Tom Kat) cost $280,000, while the new one will cost $320,000, fully financed by a 5 year 8% per annum interest only loan. The new machine will be depreciated prime cost to $50,000 over its 5 year life. Harry estimates that it will be worth $40,000 (salvage value) after 5 years. The old machine is being depreciated at prime cost to zero over its original expected life of 10 years. However, Harry can sell the old machine today for $90,000. The new machine will save Harry $80,000 a year in cooling costs. However, with the new machine, Harry will lose $10,000 per annum of existing sales to Tom Kat, which Tom has regularly bought each year over the past 5 years from Harrys business. With the new machine, a one-off amount of cleaning supplies (current assets) at a cost of $12,000 will be required, and Harry estimates that accounts receivable (also current assets) will increase by $15,000. Both of these increases in working capital will be recouped at the end of the new machines life in five years time. Harrys cost of capital is 10%. The tax rate is 30%. Tax is paid in the year in which earnings are received. Required 1. Calculate the net present value of the proposed change, that is, the net benefit or net loss in present value terms of the proposed changeover. 2. Should Harry purchase the new machine? State clearly why or why not. Answers: Harry Hill decision to buy new machine will depend on the net NPV of the cash flows from the new machine and the loss of cash flows from the old machine. The cash inflows from the new machine include tax saving on depreciation, salvage value of old machine which is no longer required, savings on cooling costs, salvage value on working capital and machine. The cash outflows include future value of the consultant fee of 1 year, Finance payments for purchasing Li Xu over a period of 5 years, loss of sales to Tom Kat, working capital investment for supplies and accounts receivable. The evaluation is given in the table below: Since the net NPV of the decision to purchase the new machine is positive (ie returns greater than cost of capital) at $ 74,000, it is prudent to purchase the new machine