Capital Budgeting

FuRox Ltd is a producer of computer components. Facing intense competition in the industry, the company has been under pressure to optimize the production process and improve productivity. The companys management team is considering purchasing a new automated machine that offers higher productivity. This purchase would mean the need for one less employee. The following day the management team carries out a feasibility study and the following data is presented to the President.

It would cost $90,000 to purchase the new automated machine and it would be expected to have a life expectancy of 5 years. Annual maintenance would be $15,000. The new automated machine will replace one employee, whose salary is $48,000. The machine will be depreciated on a straight-line basis over 5 years to a zero salvage value. To get the automated machine in running order, there would be a $10,000 shipping fee and a $10,000 installation charge.

As the new machine would work faster than the old one, investment in raw materials and goods-in-progress inventories would need to be increased in year zero by a total of $2,000. In addition, there would be the need for on-going contributions of $1,000 each year of operation in net working capital. Full recovery of net working capital is assumed at the end of the machines life expectancy.

The new machine will occupy more space in the manufacturing plant. The company currently rents a plant site at a rental cost of $100,000 per year. The management team believes that the current plant site has sufficient room to accommodate the new machine. In addition, to purchase the new machine, it appears the firm would have to borrow an additional $40,000 at 8% interest from its local bank, resulting in additional interest payments of $3,200 per year. The firm's marginal tax rate is 40 percent. The companys equity beta is 1.50. Assume the pre-tax cost of debt is 11%. The risk-free rate is 3% per annum. The market risk premium is 9% per annum. The companys weight of debt is 50% and the weight of equity is 50%.

Required

(a) Calculate the automated machines free cash flows in year 0 and show your calculations. (1 mark)

(b) Calculate the automated machines free cash flows from years 1 to 4 and show your calculations. (3 marks)

(c) Calculate the automated machines free cash flows in year 5 and show your calculations. (1 mark)

(d) On the basis of the net present value criterion, should the automated machine be purchased? Justify your answer with detailed calculations and explanations. (3 marks)

Answer rating: 100% (QA)

The Answer is in the image, click to view ... View the full answer