Question
Question 1 (25 marks) You are the Chief Operating Officer (COO) of an electrical appliances company, Sung-Sam. Currently you are considering replacing the existing old
Question 1 (25 marks)
You are the Chief Operating Officer (COO) of an electrical appliances
company, Sung-Sam. Currently you are considering replacing the
existing old assembly line with a new one in order to boost the
production capacity and product variety.
The old assembly line was purchased seven years ago at a total cost of
$2.4 million. It has a 12-year economic life with five years remaining
and zero salvage value. If this assembly line was to be sold today, it
would be worth $1 million.
The new assembly line is proposed by Pro-M, a consulting firm with
expertise in manufacturing consultancy. The proposed assembly line
is currently selling at $1.4 million. In addition, Sung-Sam would have
to incur $120,000 shipping and installation expenses and HK$80,000
investment in net working capital. The economic life of the new
assembly line is five years with zero scrap value. It is expected that
the new assembly line can reduce before- tax operating expenses by
$220,000 every year. The company has paid $20,000 to Pro-M to obtain
an evaluation report on the new assembly line.
Sung-Sam uses the straight line depreciation method on all its
production machinery and sets the cost of capital to be 18%. Assume
that the marginal tax rate is 25%.
Answer the following questions:
a
What is a sunk cost in capital budgeting? Do you agree that the
$20,000 to Pro-M is a sunk cost? Why?
(6 marks)
b
What is the initial outlay associated with this proposed purchase?
(6 marks)
16
FIN B280 Introduction to Financial Management
c What are the annual after-tax cash flows associated with this
proposed purchase for years one through to four? What is the after-
tax cash flow in terminal year (year 5)?
(8 marks)
d
Calculate the net present value (NPV) of this replacement decision.
Would you accept the purchase of the new assembly line? Explain
your reason with concept of the goal of the firm.
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