Question 1 (32 points, Investment Appraisals and Cash Flows)

ANSWER THE FOLLOWING CASES

SECTION A

The directors of Madura limited are contemplating the purchase of new machine to replace a

machine which has been in operation in the factory for the last 5 years. Ignoring interest but

considering tax at 50% of net earnings, suggest which of the two alternatives should be

preferred. The following are the details:

Details Old machine New machine

Purchase price R40 000 R60 000

Useful life 10 years 10 years

Running hours per year 2 000 2 000

Units per hour 24 36

Wages per running hour R3 R5.25

Power per annum R2 000 R4 500

Consumables per month R500 R625

All other charges per month R666.67 R750

Material cost per unit R0.50 R0.50

Selling price per unit R1.25 R1.25

Depreciation is charged on a straight line basis.

Required:

1.1 (8 points) Compare accounting profits for both old and new machine.

1.2 (8 points) Assess the returns on i) original investment, ii) average investment method

and return on incremental investment.

1.3 (4 points) Draft a recommendation on whether the old machine should be replaced or

not.

SECTION B (12 points)

ABTS Co Ltd is considering the purchase of a new machine. Two alternative machines (A

and B) have been suggested each having an initial cost of R400 000 and requiring R20 000

as additional working capital at the end of the 1st year Earnings after taxation are expected

to be as follows. All cash flows are expected at the end of each period.

Year1 Year 2 Year 3 Year 4 Year 5

Machine A R40 000 R120 000 R160 000 R240 000 R160 000

Machine B R120 000 R160 000 R200 000 R120 000 R80 000

The company has target return on capital of 10% and on this basis, you are required to

compare the profitability of the machines and state which alternatives you consider financially

preferable using the i) Payback, ii) Net Present Value and iii) Internal Rate of Return methods.