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.

Required:
(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?
ANSWER
(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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