QUESTION 4 (20 Marks)

Unican Ltd is looking to expand its operations and increase its market share in the canned food industry. To achieve this it is looking to increase its current productive capacity of 1 000 000 cans a year by at least 5% for each of the next 5 years. It is considering two canning machines and is unsure which to purchase.

Machine A can be imported at a landed purchase cost of $380 000 and a further $20 000 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 can be sold for 5% of its landed purchase cost. Net cash revenue from the sale of the additional production is expected to be $140 000 in the first year and this is expected to increase by 8% every year over the life time of the machine. This machine will enable Unican to achieve a 3% increase in productive capacity.

Machine B can be purchased locally for $300 000 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 $140 000 per annum for each of the five years. This machine will enable Unican to achieve a 2% increase in productive capacity.

Unican Ltd requires a return on capital of 12% 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 28.73% for Machine A and 36.7% for machine B

The capital expenditure committee has indicated that $700 000 is available for this capital expenditure. In terms of the company's capital expenditure policy, only projects with a payback period of less than three years are accepted.

REQUIRED

You are the financial manager at Unican Ltd 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.