QUESTION FIVE

Body Builders Ltd (BBL) is a manufacturing company operating in Melbourne. It manufactures specific body parts for major vehicles to the specification of vehicle manufacturers. The management of this company is considering the acquisition of a new equipment to mould and produce parts efficiently and economically. An environmental consultant was engaged prior to the investment decision to evaluate the feasibility of this proposed change. This consultation was necessary regardless of the decision to proceed with the acquisition. The consultant invoiced BBL $10,000 in the same period as the purchase of the new equipment. This new equipment has approximately twice the capacity of the old equipment and provides operating efficiencies in labour and power usage. The machine has been designed to reduce noise and carbon emission.

Additional information:

1.The savings in operating costs are estimated to be $1,015,000 annually for five years.

2.The new moulding equipment would cost $2,550,000 and would be purchased and paid at the beginning of the year.

3.The equipment is installed, tested and operational during the second quarter of the following year. It is expected only 60 per cent of the estimated yearly savings can be obtained in the first year.

4.Equipment depreciation will remain not affected by the year 1's lower operations. The taxation depreciation on the new equipment would be 20 per cent using the straight-line method. The new equipment has a salvage value of $50,000 at the end of its estimated 5-year useful economic life.

5.BBL's investment in the equipment qualifies for a 5 per cent investment allowance from the Australian Government and is expected to be received on completion of the installation.

6.BBL's management has reviewed its condition and concluded that if the new equipment was not purchased, then the old equipment could continue to be used for additional three years. Since the company decided to purchase the new equipment, it would receive $200,000 net of removal costs for disposing the old equipment (assume amount is received at the end of the installation).

7.BBL is subject to a 30 per cent income tax rate and the BBL's WACC is 12 per cent, thus expects at least 12 per cent return from the investment.

REQUIRED:

a.What type of investment is BBL considering?Provide details as to why you came to this conclusion.

b.Calculate the net present value (NPV) of the proposed new equipment, using the cash flows method. Provide all calculations.

c.Advise the management of BBL on whether they should proceed with the project.