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QUESTION 4 You are the Finance manager for an established electronic company. The company is considering replacing the existing equipment used in its manufacturing process.
QUESTION 4 You are the Finance manager for an established electronic company. The company is considering replacing the existing equipment used in its manufacturing process. You instructed a junior finance executive to analyse several options and come out with a report to be presented to the top management, Five days later, you received the report from the junior executive as follows: Proposal : To replace the existing Equipment AA with new Equipment BB Cost : RM10 million Expected useful life Expected incremental profit : RM9.9 million over four-year period (see details below) : 4 years Gross profit Administrative and distribution expenses Depreciation Profit before tax Tax Profit for the year Year 1 Year 2 Year 3 RM000 RM000 RM'000 8,500 8,500 8,500 3,200 3,200 3,200 2,500 2,500 2,500 2,800 2.800 2,800 700 700 700 2,100 2,100 2,100 Year 4 Total RM'000 RM'000 8,500 34,000 3,200 12,800 2,500 10,000 2,800 11,200 700 2,800 2,100 9,900 4 You do not agree with the way the report was prepared and decided to prepare a report on your own. You have made some enquires and obtained the following information: i. The depreciation for proposed Equipment BB is calculated on straight-line basis, with zero salvage value. This is in line with what the accounting department recommended. The same basis is also used for tax purpose. ii. It is expected that at the end of its useful life, Equipment BB can be sold as scrap for RM5,000. This was not considered in the report. iii. The existing Equipment AA was bought 3 years ago at the cost of RM1,550,000 and has a useful life of 5 years with a salvage value of RM50,000. If the new Equipment BB is purchase, Equipment AA can be traded in for RM620,000. If the company does not purchase Equipment BB, Equipment AA can still be used for another 4 years and afterwards can be sold as scrap for RM2,000. None of these has been included in the report. iv. The report also has not factored in the fact that the new equipment will require RM150,000 in working capital upfront, which will be fully recovered at the end of the equipment's life. RM1,400,000 of the administrative and distribution expenses in the report is overhead that will be incurred even if the company decided to continue using the existing Equipment AA. vi. Despite the misleading analysis prepared by the junior executive, you agree with him that Equipment BB is the best available option for the proposal. vii. The company's weighted average cost of capital is 15%. viii. The maximum acceptable payback period is 2 years. V. Required: a) Estimate the relevant cash flows associated with the proposed replacement. (12 marks) b) Using payback period, net present value and internal rate of return evaluate whether the company should replace the existing Equipment AA. (Give answer up to 2 decimal places) (8 marks) c) Leasing of equipment BB is the alternative to outright purchase. Explain the advantages of leasing as compared to outright purchase. (5 marks) (Total: 25 marks)
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