Andy Pratt, a mechanical engineer and the founder of the Protea Sports Company (PSC), had developed a sound technique of making cricket bats. Recently, however, a new machine had been developed in the industry, which would allow manufacturers to coat the aluminium cricket bats with a specific compound giving them a satin finish and making them more durable and powerful. The new machine has an initial price tag of R350,000 and users would incur shipping, handling, and installation costs of R4,500 and annual fixed operating costs of about R20,000 per machine. Currently the company incurs fixed operating costs of R28,000 for its coating and finishing process. Unit sales on the newly designed cricket bats would increase by about 15% in the first year of introduction and thereafter at a rate of 5% per year compared with the forecasted unit sales growth of 2% per year for the current type of cricket bats. During the most recent year, PSC sold 220,000 cricket bats at an average price of R12.50 per unit. The newly designed bat was expected to sell for R13 per unit. Material labour, general and administrative costs were expected to remain constant at R10 per unit. The increased sales and production requirements would entail an increase in accounts receivables of R54,000, an increase in accounts payables of R30,000, and an increase in inventory of R20,000. It was assumed that any increase in net working capital would be recovered at the end of the useful life of the machine, which was estimated to be 10 years. The existing machine was purchased 5 years ago for R225,000. The depreciation on the existing machine was being calculated using a 15-year straight-line depreciation schedule with the assumption of no residual salvage value. The machine had a current market value of R100,000, and an expected market value of R10,000 after 10 more years of use. The new machine is expected to last for ten years, the same as the remaining life of the old machine. The new machine has been qualified for the 5-year life asset class by SARS for depreciation purposes and would also be depreciated on a straight-line basis. It is expected to have a market value of approximately R20,000 at the end of its economic life. PSCs marginal tax rate is 30% and its weighted average cost of capital is estimated at 15%. Part of the cost of replacing the existing machine would be financed by a bank loan that would require an annual interest expense of 10% on the outstanding balance. Andy knows that the new technology is the way to go. However, being cautious and conservative by nature, he does not want to implement changes that would be financially detrimental to his company. After all, he has worked too hard to let it all slip away by making lousy financial decisions. Andy has long believed in the age-old saying, If the coat fits wear

Case Questions You have been asked to prepare a capital budgeting report indicating whether PSC should replace the existing machine or not. 1. Explain the relevance of incremental cash flows and sunk costs in the context of this case. [2 marks] 2. What are the relevant factors and items to be considered when estimating the initial outlay? Calculate the initial outlay for this replacement project. [3 marks] 3. If inflation is expected to be at least 3% per year, what effect would this have on your analysis? [3 marks] 4. How are the free cash flows to be computed for the productive life of the new machinery? How is the depreciation to be accounted for? What is the depreciation schedule for this project? [3 marks] 5. How should the annual interest expenses on the bank loan be handled? Explain. [3 marks] 6. What is the relevance of the terminal year cash flow? Which factors must be considered when estimating the terminal year cash flow? [3 marks] 7. Assume there is no inflation and calculate the relevant incremental free cash flows for the replacement project. [Hint: Use the template (Table 1.1) given on the following page] [26 marks] 8. Using an appropriate capital budgeting technique, make a recommendation to Andy regarding the replacement of the old coating machine?