Question
Harry Hill is considering replacing an old machine with a new one from Li Xu because one year ago a feasibility study on the new
Harry Hill is considering replacing an old machine with a new one from Li Xu because one year ago a feasibility study on the new machine conducted for Harry by PQ Ltd, an external firm of consultants, costing Harry $25,000, concluded in favour of buying this new machine. The old machine (bought 5 years ago from Tom Kat) cost $300,000, while the new one will cost $350,000, fully financed by a 5 year 9% per annum interest only loan.
The new machine will be depreciated prime cost to zero over its 5 year life. Harry estimates that it will be worth $40,000 (salvage value) after 5 years. The old machine is being depreciated at prime cost to zero over its original expected life of 10 years. However, Harry can sell the old machine today for $80,000.
The new machine will save Harry $90,000 a year in cooling costs. However, with the new machine, Harry will lose $10,000 per annum of existing sales to Tom Kat, which Tom has regularly bought each year over the past 5 years from Harrys business.
With the new machine, a one-off amount of cleaning supplies (current assets) at a cost of $12,000 will be required, and Harry estimates that accounts receivable (also current assets) will increase by $15,000. Both of these increases in working capital will be recouped at the end of the new machines life in five years time.
Harrys cost of capital is 10%. The tax rate is 30%. Tax is paid in the year in which earnings are received.
REQUIRED
Calculate the net present value of the proposed change, that is, the net benefit or net loss in present value terms of the proposed changeover.
Should Harry purchase the new machine? State clearly why or why not.
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