AAA Ltd is considering replacing an existing production line with a new line that has a greater output capacity and operates with less labour than the existing line.

Existing Production line

The old line was constructed 5 years ago for $300,000. It had an expected useful life of 10 years and an estimated market value of zero at the end of its life. If you sell the old line now, it is expected to be sold for $100,000.

New Production line

You have just completed a $50,000 feasibility study for a new production line. The new line would cost $1,000,000, has a 5-year life and is expected to be sold for $100,000 at the end of its life. Because the new line is more automated, it would require fewer operators, resulting in a saving of operating expense of $100,000 per year. The new line is however expected to have a negative impact on other side of the business and an annual operating cost of this side effect is expected to be $40,000 per year. Additional sales with the new machine are expected to result in additional net cash inflows of $250,000 per year. To support the increased business resulting from the new production line, accounts receivables are expected to increase by $70,000, inventories by $40,000 and accounts payables by $58,000. The investment in working capital will be recovered in the terminal year.

a) Calculate free cash flows from Year 0 to Year 5. (10 marks)

b) Calculate the standard payback period. If the cut-off year is 3 years, should AAA Ltd accept the new project and why? (2 marks)

c) Calculate the NPV. Should AAA Ltd accept the new project and why? (3 marks)

d) Establish the equation from which the IRR is solved. Assuming the IRR=15.94%, should AAA Ltd accept the project and why? (3 marks) AAA Ltds production lines are depreciated using the straight-line method, the tax rate is 30% and the opportunity cost of capital is 10%.