Financial management revision question and answer

CPA-Financial-Management-Section-3 Revision kit

Alima Ltd., a manufacturer of edible oils, is contemplating the purchase of a new oil processing machine to replace the existing one. The existing machine was acquired two years ago at a cost of Sh.4,000,000. the useful life of this machine was originally expected to be five years with no salvage value, but after a critical analysis, the financial analyst has now estimated that the machine will have an economic life of ten years with a salvage value of Sh.500,000. The new machine is estimated to cost Sh.8,000,000 and Sh.400,000 would be incurred in installing the machine. The new machine is estimated to have a useful life of ten years. An expert in asset valuation estimates that the existing machine can be sold at Sh.2,500,000 in the open market. The new machine is expected to lead to increased sales. To support the increased sales, debtors would increase Sh.320,000, stock Sh.140,000 and creditors Sh.300,000. The estimated profit before depreciation and tax over the next ten years for the two machines is as given below.


The company‟s cost of capital is 10%. Corporation tax applicable is 30%. The company uses the straightline method of depreciation.

Required:

(i) Initial investment required replacement of the old machine. (4 marks)
(ii) An evaluation of whether it is worthwhile for to undertake the replacement of the machine.
ANSWER
i). The net book value (NBV) of existing asset after 2 years is 4m – (4m/5yrs x 2 years) = 2.4m


– Operating cash flow = incremental EBDT (I-T) + Tax shared where incremental EBDT = EBDT (new asset) – EBDT (old asset)

It is not worthwhile to replace the machine.

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