Part I

(1) TPM has an after tax cost of capital of 12%; it willpay 9% on any new bank borrowing;the current tax rate is 30%.

(2) A new manufacturing technology has just become available. Adopting this new technology requires TPM to upgrade its manufacturing equipment. Compared to the existing technology,the new technology is faster and requires fewer workersbut at the same time isless environmentally friendly.

(3) Thecurrent pulp mill equipment has an annual output of 500,000 air dried tonnes (ADt)of pulp which currently sellsat $124 per tonne. In contrast,the new equipment will have an annual output of 600,000 ADt of pulp.

(4) The current equipment was purchased three years ago for $49,000,000. It hasa book value of $28,000,000andanother four years of life remainingwith no salvage value. It can besold on the secondary market today for $11,000,000.The new equipment costs $75,000,000(will be fully funded by bank loans) and is expected tolast five yearswith an estimatedsalvage value of $15,000,000. The new equipment will immediatelyreduce net working capital (NWC) by $12,000,000.

(5)The current equipment requires annual fixed cash costs(including overhead and operating) of $4,150,000, while thenew equipment requires $3,780,000.

(6) Manufacturing pulp using the current equipment incurs the following costs (per tonne) in addition to the costs stated in (5): labour $33.5, material $36.5, variable overhead $14.25, and fixed overhead $16.5. The corresponding figures for the new equipment are $17.45, $30.20, $12.55, and $20.25, respectively.

(a)From the perspective of capital budgeting, should TPM upgrade to the new technology or continue to operate using its current equipment?

(b) Conduct risk evaluations (using the sensitivity analysis) of adopting the new technology by considering the following factors: output using the new technology may be overestimated; the reduction in NWC may be overestimated; due to continuous development in the industry,the equipment may worth less than $15,000,000 in five years; the labour cost per tonne may be underestimated.