Question
Allied Assembly (Pty) Ltd is considering purchasing a new machine to replace an existing machine. The existing machine was purchased three years ago at a
Allied Assembly (Pty) Ltd is considering purchasing a new machine to replace an existing machine. The existing machine was purchased three years ago at a cost of R360 000, and installation cost amounted to 140 000. The existing machine is depreciated on a straight-line basis over its useful life of five years.
The new machine will cost R600 000 plus installation cost amounting to R100 000. The existing machine can currently be sold for R350 000. If the existing machine is used until the end of its economic lifetime of five years, its expected resale value will be zero.
The new machine has a useful life of five years and is depreciated using the straight-line method. It is expected that two years from now, the new machine can be sold for R460 000 at the end of its useful life. Replacing the existing machine with the new machine is expected to increase Allied Assembly (Pty) Ltds Net Operating Profit After Tax (NOPAT). The projected NOPAT for the existing machine and new machine is provided in the table below.
YEAR | Projected NOPAT Existing machine | Projected NOPAT New machine |
1 | R100 000 | R200 000 |
2 | R100 000 | R200 000 |
To support the additional business resulting from the purchase of the new machine, accounts receivable will increase from R70 000 to R130 000, inventory will increase from R30 000 to R60 000, and accounts payable will increase from R60 000 to R70 000.
Allied Assembly (Pty) Ltds weighted average cost of capital (WACC) is 12%. Assume a tax rate of 28%.
REQUIRED:
Calculate the net present value (NPV) of the proposed replacement. (25)
Note, your calculation must be supported by workings for:
- The initial investment associated with the proposed replacement decision.
- The incremental operating cash flows associated with the proposed replacement.
- The terminal cash flow associated with the proposed replacement decision.
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