Financial management revision question and answer

CPA-Financial-Management-Section-3 Revision kit

Mwamba Limited is considering replacing a production machinery at its Mtwapa plant. The existing machinery at the plant was bought 3 years ago at a cost of Sh.50 million. It is expected to have a useful life of 5 more years with no scrap value at the end of this period. The machinery could be disposed of immediately with net proceeds of Sh.35 million after tax.

The new machinery will cost Sh.80 million, with a useful life of 5 years and expected terminal value of Sh.5 million. With the introduction of the new machinery, sales are expected to increase Sh.25 million per annum over the next 5 years. Variable costs are 60 per cent of sales and the corporate tax rate is at 30 per cent per annum.

The operation of the new machinery will also require an immediate investment of Sh.8 million in working capital which will be recovered at the end of its useful life. Installation costs of the new machinery will amount to Sh.6 million.

Assume that capital allowances are to be provided for on a straight-line basis and
Mwamba Limited‟s cost of capital is 12 per cent per annum.

Required:
(i) The initial cash outflow for the replacement decision. (3 marks)
(ii) The annual incremental after tax operating cash flows. (4 marks)
(iii) The NPV of the replacement decision and advise Mwamba Limited on whether to replace the machinery. (7 marks)

(iv) The minimum after tax annual operating cash flows that will make the replacement feasible. (3 marks)
ANSWER

i). The net book value of existing machine would be :

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