Question 3

Wallaroo Company is considering the purchase of a new lathe machine and must decide between two possible machines. It is expected that it will be a repeated investment into the foreseeable future. The relevant data associated with each machine is shown below.

Machine A

Machine B

Initial cost

$300 000

$400 000

Installation cost

$25 000

$32 000

Life (years)

5

8

Increase in annual revenues

$180 000

$240 000

Increase in annual expenses

$95 000

$160 000

Salvage value

$30 000

$55 000

Required

Part (a) Ignoring all tax implications of this decision and assuming the company has a required rate of return of 10 per cent, which machine should the company select? Explain why.

[8 marks]

Part (b) What is opportunity cost in the context of capital budgeting and why should it be taken into account? Give an example explaining how it is an opportunity cost.

[4 marks]

Part (c) Why might FCF in the terminal year of a project's life differ from FCF in the other years?