Perfect Binding Ltd provides specialist binding services to the printing industry. The companys production manager is investigating whether to replace an old burst binding machine and has provided you with the following information:

• The old binder was bought five-years ago for $90,000 and has been depreciated by $6,000 a year on a straight line (prime cost) basis for tax purposes. Analysis of the second-hand market for binders indicates that the old binder has a salvage value of $30,000 if it was sold today and $0 salvage value if it was sold at the end of its normal useful life.
• The new binder costs $100,000, has a useful life of ten years and is depreciated on a straight line basis over its useful life. The main advantage of the new binder is that it will generate additional cash revenues of $35,000 per year, although it also generates additional cash expenses of $12,000 per year. Finally, the new binder will have a salvage value of $10,000 at the end of its ten year life.
• Perfect Binding pays 30% tax in the year income is earned and uses a 10% p.a. discount rate for project evaluation. Finally, there will be no replacement of the burst binding machine in ten years time.

(a) In calculating the net present value (NPV) of this investment, why does the firm include depreciation when depreciation is not a cash flow?

(1 mark)

(b) Using the above information, prepare a detailed discounted cash flow analysis relevant to the managers decision. With your analysis, you must include advice on whether the company should replace the binder.

(10 marks)