Financial management revision question and answer

The Pesa Company Unlimited is using a machine whose original cost was Sh.720,000. The machine is two years old, and it has a current market value of Sh.160,000. The asset is fully being depreciated over a twelve-years period. At the end of the twelve-years the asset will have a zero salvage value. Depreciation is on a straight line basis.

The Management is contemplating the purchase of a new machine to replace the old one. The new machine costs Sh.750,000 and has an estimated salvage value of Sh.100,000. The new machine will have a greater technological capacity, and therefore annual sales are expected to increase from Sh.10,000,000 to Sh.10,100,000. Operating efficiencies with the new machine will produce an expected saving of Sh.100,000 a year. Depreciation would be on a straight line basis over a ten-year life. The cost of capital is 12%, and a 40% tax rate is applicable. In addition, if the new machine is purchased, inventories will increase sh.150,000 and payables Sh.50,000 during the life of the project.

(a) Should the new machine be purchased? (Use Net Present Value (NPV) approach).
(b) What factors in addition to the quantitative ones above are likely to require consideration in a practical situation?
(a) Net book value (NBV) after 2 years =

Increamental initial capital:

(b) Other factors:
– Technological changes and its effects on new machine
– Risk inherent in the use of new machine
– Availability of spare parts for new asset
– Availability of capital
– Uncertainty and accuracy of cash flow estimates
– Demand in the market to absorb extra production

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