Faheem Butt, the production manger of Ittefaq Foundries Ltd. (IFL) has just come to know that Crescent Engineering Ltd. (CEL) has recently introduced a new fabrication machine for medium size foundries. The new model is more efficient that the currently available models. Faheem thought that if the new machine were economically attractive, he could discuss with general manager of the company the possibility f replacing the existing machine, which his company had bought five years age. He therefore decided to collect the technical and financial information of the machine from CEL. Amjad the marketing manager of CEL, explained to Faheem the technical features of the machine, and tried to convince him that his company should go for the new model as it was for superior to their existing machine. Faheem asked him the financial details of buying the new model. He informed Amjad that the existing machine has annual operating cost of Rs. 600,000, Amjad stated that IFL would incur annual operating cash cost of Rs.250,000 and thus will be able to save cash costs of Rs. 350,000 per year. In addition to these savings, IFL would charge straight line depreciation on the new machine, which will save taxes for the company. He also felt that the new machine would have a salvage value equal to 10 percent of its original cost at the end of its useful life of 10 years. The machine will cost Rs.1,600,000 plus Rs.200,000 as installation cost. Faheem knew that his company had bought the existing machine five years ago for Rs.600,000 and the installation cost was Rs.100,000. The book value of the machine, after charging straight line depreciation for tax purpose, is Rs. 35,000. The machine, if sold today, could fetch a price of Rs.75,000; if it is not replaced, it could be sold for Rs. 125,000 at the end of the original economic life of 10 years. IFL is a cash rich company. It is entirely equity financed and it has no plans for using long term debt in the near future to finance its projects. If it decides to replace the old machine, it will utilise internal cash. IFL is a privately held company. It has a practice of measuring its cost of capital by adding premium for inflation and risk to the yield on one-year long term government bound, which is currently 6 percent. According to the company management, the expected inflation rate is 5 percent and the risk premium is 7 percent. However, for replacement decisions the company considers a risk premium of 4 percent as reasonable. IFL corporate income tax rate is 35 percent.

Required: 1. Compute Cash Flows. Make your assumptions explicit. (Marks 7) 2. Which alternative should the company choose and why? Explain the logic of the procedure followed by you.