Mapato Limited is a company involved in the processing of cooking oil. The management is considering whether to replace an existing cooler with a new one.
The old cooler is fully depreciated and has no salvage value. If not replaced, the company will continue to incur Sh.1.8 million as annual operating expenses and an additional Sh.500,000 in repair costs per annum over the next fifteen years.
The new cooler costs Sh.3,150,000. Its annual operating expenses and repair costs are estimated at Sh.1.3 million and Sh.350,000 respectively over its estimated economic life of fifteen years. It is expected to be worthless after the expiry of this period.
The cost of capital is 10% and the company depreciates its assets using the straight-line method.
Assume a 30% corporation tax rate.
(i) Compute the incremental net annual cash flows if the old cooler is replaced.
(ii) Using the net present value (NPV) method, advise the management on whether or not to replace the old cooler.