Financial management revision question and answer

Mumias Milling Company purchased a grinder 3 years ago at a cost of Sh.3.5 million. The grinder had a life of 8 years at the time of purchase. It is being depreciated at 15% per year on a declining balance. The company is considering replacing it with a new grinder costing Sh.7 million with an expected useful life of 5 years.

Due to increased efficiency, the profit before depreciation is expected to increase Sh.400,000 a year. The old and new grinders will now be depreciated at 25% per year on a declining balance for tax purposes.

The salvage value of the new grinder is estimated at Sh.210,000. The market value of the old grinder, today, is Sh.4 million. It is estimated to have a zero salvage value after 5 years.

The company‟s tax is 30% and the after tax cost of capital is 12%.

Required
Should the new grinder be bought? Explain.
Answer
The old grinder still has 5 more years. Determine the NBV (today) after the lapse of 3 years using 15% depreciation rate.


The depreciation for the first 3 years is a sunk or historical variable, irrelevant in replacement decision.
Carry out the increamental analysis using the fifth steps
(i) Compute increamental initial capital


(ii) Compute increamental depreciation using 25% depreciation rate on reducing balance basis – over a period of 5 years.


(iii) Compute increamental salvage value
Salvage value of new machine         210
Less: old machine                                  0
Increamental salvage value end of year 210 5

(iv) Compute annual operating cash flows and NPV using 12% cost of capital. In deriving the operating cash flows:
Recall:
If increamental EBDT > Increamental depreciation p.a. then operating cash flows will be derived as:
EBDT less depreciation, EBT less Tax,
Add back
Depreciation, EAT
EBDT XXX
Less: Depreciation XX
EBT XX
Less Tax X
EAT XX
Add back depreciation XX
Operating cash flows XX

If EBDT < Incremental depreciation p.a.
Then operating cash flows = EBDT(1 – T) + DTS
Where DTS = Depreciable tax shield = Depreciation p.a. x tax rate.

Increamental depreciation for each year is higher than increamental EBDT of Ksh.400,000 p.a.

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