Advanced: Net present value calculation for the replacement of a machine and a discussion of the conflict between ROI and NPV Eckard pic is a large, all-equity financed, division¬ alized textile company whose shares are listed on the London Stock Exchange. It has a current cost of capital of 15%, The annual performance of its four divisions is assessed by their return on invest¬ ment (ROI), lib. riet profit after tax divided by the closing level bf capital employed. It is expected that the overall ROI for the company for the year ending 31 December 2000 will be 18%, with the towelling division having the highest ROI of 25%. The towelling division has a young, ambitious managing director tVho is anxious to maintain its ROI for the hext two years, by which time he expects to be able to obtain a more prestigious job either within Eckard pic or elsewhere. He has recently turned ddwn a proposal by his division’s finance directbt td replace an old machine with a more modem bne, on the grounds that the old one has an estimated useful life offour years and should be kept for that period. The finance director has appealed to the main board of directors of Eckard pic to reverse her managing director’s decision.

The following estimates have been prepared by the finance director for the new machine:

Investment hos'd £256 000, payable on 2 January 2001.

Expected life: four years to 31 December 2004.

Disposal vdlueI equal to its tax written down value on 1 January 2004 and receivable on 31 December 20Ci4.

Expected cash flow savings: £60 000 in 2001, rising by 10% in each of the next three years. These cash flows cah be assumed to occur at the end of the year in which they arise.

Tax position: the company is expected to pay 35% corporation tax over the next four years. The machine is eligible for a 25% per annum writing down allowance. Corporation tax can be assumed to be paid 12 hionths after the accounting year-end on 31 December. No provision for deferred tax is considered to be riecessary.

Old machitie to be replaced: this would be sold on 2 January 2001 with an accounting net book value of £50000 and a tax written down value of nil. Sale proceeds would be £40 000, which would give rise to a balancing charge. If retained for a further four years, the disposal value would be zero.

Relevant accounting policies: the company uses the straight-lihe depreciation method with a full year’s depreciation being charged in both the year of acquisition and the year of disposal. The capital employed figtire for the division comprises all assets excludihg cash.

CAPITAL INVESTMENT DECISIONS: 2 531 Requirements

(a) Calculate the net present value to Eckard pic of the proposed replacement of the old machine by the new one. (8 marks)

(b) Calculate, for the years 2001 and 2002 only, the effect of the decision to replace the old machine on the ROI of the towelling division.

(7 marks)

(c) Prepare a report for the main board of direc¬ tors recommending whether the new machine should be purchased. Your report should include a discussion of the effects that perfor¬ mance measurement systems can have on capital investment decisions. (10 marks)

(Total 25 marks) ICAEW P2 Financial Management