Question 1 [26 marks]

A manufacturing company is considering replacing an old machine with a new one. The risk-free rate of return is given as 4% p.a. The yearly return for the share market is given as 12%. Suppose a listed company has a beta value of 0.75. The shareholders of the company cannot benefit from imputation credits. The old machine was purchased 5 years ago for $100,000 and is expected to have a useful life of 10 years and zero salvage value. If the company sold the old machine today, it would receive $40,000. The new machine will cost $75,000 and is expected to have a useful life of 5 years with zero salvage value. The old machine has maintenance costs of $10,000 per year whereas the new machine has maintenance costs of $1,000 per year. The new machine will also reduce the cost of defects from $5,000 per year to $1,000 per year. The company uses straight-line depreciation, and assumes a company tax rate of 30%.

• What is the investors required rate of return for the companys shares?
• marks)
• If the company is either a taxation category 1 or a taxation category 2 company, to which taxation category does the company belong. Would capital budgeting for the company be performed on a before-tax or an after-tax basis?
• marks)
• If the old machine were sold today identify the annual depreciation expense and the tax savings for the old machine.

(3 marks)

• Calculate the initial outlay for the project.

(2 marks)

• Calculate the annual depreciation expense for the new machine and determine the net cash flows for years 1-5 of the project.

(6 marks)

• Discuss what the payback period identifies and therefore why it is readily used.

(2 marks)

• Calculate the payback period. What are the weaknesses of the payback period method for evaluating projects?

(3 marks)

• Calculate the net present value (NPV), profitability index (PI) and internal rate of return (IRR) of the project.

(4 marks)

• Is the project an acceptable investment? Explain your answer.