BANKING AN y2 – A manufacturing company is considering replacing an old machine

Subject: Business    / Finance
Question

A manufacturing company is considering replacing an old machine with a new one. The risk-free rate of return is given as 4% p.a. The yearly return for the share market is given as 12%. Suppose a listed company has a beta value of 0.75. The shareholders of the company cannot benefit from imputation credits. The old machine was purchased 5 years ago for $100,000 and is expected to have a useful life of 10 years and zero salvage value. If the company sold the old machine today, it would receive $40,000. The new machine will cost $75,000 and is expected to have a useful life of 5 years with zero salvage value. The old machine has maintenance costs of $10,000 per year whereas the new machine has maintenance costs of $1,000 per year. The new machine will also reduce the cost of defects from $5,000 per year to $1,000 per year. The company uses straight-line depreciation, and assumes a company tax rate of 30%.

What is the investors’ required rate of return for the company’s shares?
marks)
If the company is either a taxation category 1 or a taxation category 2 company, to which taxation category does the company belong. Would capital budgeting for the company be performed on a before-tax or an after-tax basis?
marks)
If the old machine were sold today identify the annual depreciation expense and the tax savings for the old machine.

(3 marks)

Calculate the initial outlay for the project.

(2 marks)

Calculate the annual depreciation expense for the new machine and determine the net cash flows for years 1-5 of the project.

(6 marks)

Discuss what the payback period identifies and therefore why it is readily used.

(2 marks)

Calculate the payback period. What are the weaknesses of the payback period method for evaluating projects?

(3 marks)

Calculate the net present value (NPV), profitability index (PI) and internal rate of return (IRR) of the project.

(4 marks)

Is the project an acceptable investment? Explain your answer.

(2 marks)