NEW MACHINE

The recent addition of machine to manufacture MDF had turned out to be a relatively successful move for Morgan. On the other hand, the older timber machine, named EXIST, being used by Morgan was in need of constant repair mainly due to its age as it had not been replaced for a long time. A report provided by the machines manufacturer suggested that an overhaul of the machine was possible which would add extra life to the machine.

Another option for Richard was to instead invest in a new machine that would offer increased capability and reduced maintenance. Richard had done a preliminary research on what kind of machines were available to suit the business needs and he had his sights set on a newer machine called NEW19 which is being supplied by a supplier based in the US. Richard believed this new machine would help bring back Morgan to its more successful years in the times ahead. The new machine would require a significant initial investment, however, and Richard had to carefully consider this investment option before he could decide whether to overhaul the existing machine or to replace it with the new one.

If Richard opted to keep EXIST (the existing machine), it could be used for a further five years at the end of which it could be sold as scrap for 35,000. Until then, Morgan would continue to claim capital allowance or depreciation of 7,000 per year for each of the next five years. Regular maintenance expense of 25,000 per year would have to be incurred to keep the machine in serviceable condition. EXIST also was in need of immediate repair works for which a quote of 40,000 has just been received; this amount needs to be paid upfront if the repair work is to be carried out. Additionally, another one-off expense of 9,000 was expected in three years time to deal with scheduled maintenance.

However, if Richard indeed decided to sell off EXIST now, it was expected to fetch 50,000 against the current book value of 70,000.

This amount could be used towards purchase of the newer machine NEW19 which could provide Richard with a more reliable timber machine with an expected life of 10 years. NEW19 costs 300,000 and can be depreciated on a straight line basis or (capital allowance can be claimed) at 10% per year. Though the expected life was 10 years, Richard plans to use it only for five years and then sell it off to purchase something more technologically advanced at that time. Given the current market situation, Richard expects to sell it at 45,000 five years down the line. As the market for such machinery is also competitive currently, the manufacturer/seller of NEW19 is offering a very reasonable maintenance plan to Morgan. Such maintenance plan would cost 5,000 in the first year, which would then increase by 1,000 per year thereafter. All such payments would have to be paid at the end of the respective years. To fund the purchase, Morgans bank has offered a five-year loan facility at 8% per year, with only the interest part payable in the first four years, and the full principle and interest being payable at the end of the five-year term.

Due to the use of more recent technological innovation in NEW19, it is expected that Morgan will be able to achieve operational efficiency leading to significant savings in both electricity and labour costs. Electric power consumption was expected to be lowered by 18% in the first year of commissioning of NEW19. This would not only lead to significant savings - electricity costs averaged 8.0 per hour, 24 hours a day, seven days a week, in a 50-week year but would also give Richard an opportunity to advertise how his company was moving towards more sustainable goals to help the environment. After the first year, savings on electricity was expected to be an additional fixed amount of 1,000 per year. Like savings in electricity, labour cost was expected to be lowered by 12% in the first year; and this saving was expected to be increased by additional 2,000 every year from second year onwards. Existing labour cost at Morgan is 200 per hour in total, based on a 35-hour week in a 50-week year.

Cost of capital is 14.7 %

Calculate the free cash flows related to the potential investment in the new machine for the purpose of calculating Net Present Value (NPV).