QUESTION 2 (25 Marks)

Cellular Traders Limited is looking to expand its operations and increase its market share in the cell phone industry. To achieve this, they are looking to increase its current productive capacity of 1 000 000 cell phones a year by at least 6% for each of the next 5 years. It is considering two cell phone making machines and is unsure which to purchase:

Cell Phone Machine A:

Cell Phone Machine A can be imported at a landed purchase cost of R800 000 and a further R200 000 transport and installation costs will have to be incurred to get it ready for production. This machine is expected to last 5 years after which time it cannot be sold. Net cash flow from the sale of the additional production is expected to be R220 000, R280 000, R400 000, R420 000 and R200 000 respectively over the 5-year lifespan of the machine. This machine will enable Cellular Traders Limited to achieve a 4% increase in productive capacity

.Cell Phone Machine B:

Cell Phone Machine B can be purchased locally for R1 000 000 and will also have a useful life of 5 years. It will not have any resale value at the end of the 5 years and will be disposed of. Net cash inflows from additional production will amount to R300 000 per annum for each of the five years. This machine will enable Cellular Traders Limited to achieve a 2% increase in productive capacity.

Additional information:

Cellular Traders Limited requires a return on capital of 15% for all investments made. The depreciation policy is to depreciate all non- current assets on a straight-line basis. Assume that all cash flows occur at the end of each financial year except for the initial investment which occurs in period 0.

It has already been determined that the internal rate of return is 15.23% for Cell Phone Machine A and 16.19% for Cell Phone Machine B

You are the financial manager at Cellular Traders Limited and have been asked by the Board of Directors to advise them on which machine/s to authorise for purchase. Using appropriate capital budgeting techniques compile a report to the Board of Directors detailing the option that should be chosen.