Question 2 (22 Marks)

Mutonhodza Project Consultants, a tile making company is currently looking into expanding its operations and increase its market share. To do that Its current productive capacity of 10 000 000 tiles per year is to be increased by at least 5 percent for each of the next five years. Two tiles making machines, namely Machine Gamma and Machine Vega are being considered and it is uncertain which one to buy. Machine Gamma can be imported from Botswana for a retail price of BWP283 000 which is equivalent to R380 000 and additional transport and installation costs of R20 000 would have to be incurred in order to get it ready for production. This machine is supposed to be depreciated on a straight-line basis towards a salvage value of 5% of the retail price but it has five years of remaining life. In the first year, net cash inflow from the sale of additional output is estimated to be R140 000 and this is expected to rise by 8 percent per year over the machine's lifetime. This machine will enable Mutonhodza to achieve a 6% increase in production capacity. Machine Vega can be purchased locally at a cost of R300 000, and its estimated useful life is 5 years. It is estimated that its salvage value at the end of the 5 years will be zero and therefore will be disposed of. For each of the five years, net cash inflows from additional output would amount to R140 000 per annum. This system will enable Mutonhodza to achieve a production capacity increase of 4 percent. For all investments made, the opportunity cost of capital for Mutonhodza is 12 percent. The companys depreciation policy states that all non-current assets are to be depreciated using straight line method. The Internal Rate of Return (IRR) has already been calculated to be 28.08 percent for Machine Gamma and 37 percent for Machine Vega. Darlington Maseko, the Capital Expenditure manager has stated that R700 000 is available for spending and only projects with a payback period of less than three years will be approved under the company's capital spending strategy.

Required As a Project Finance expert for Mutonhodza Consultants, you have been tasked by the Board of Directors to advise them on which machine(s) to approve. Using the Payback approach, Accounting Rate of Return (ARR) and Net Present Value (NPV) techniques, compile a report to the Board of Directors detailing the option that should be chosen.