Question Four CASH FLOW ANALYSIS

Right Drive Tyres Ltd has just completed a $20,000 feasibility study into automated machines and is now considering the replacement of a manually operated machine with a fully automated one. Currently, the manual machine needs three full time operators to operate it, costing the company $150,000 in wages annually. Maintenance costs for the manual machine are $18,000 per year. The machine was purchased seven years ago at a cost of $180,000 and at the time was expected to run for a life of ten years before being scrapped. It is being depreciated straight line. However, if Right Drive Tyres were to sell the machine at the current market price today it will get $45000.

The automated machine will cost $450,000 to purchase with further shipping and installations costs of $40,000. The automated machine costs more to maintain at $24000 per year, and will reduce the cost of defects from $12,000 per year for the manual machine to $2,000 per year. The new machine will be depreciated straight line over its expected life of seven years, with an expected salvage value of $25000. The manual machine can run for another seven years, but will need an overhaul at the end of the third year at a cost $75,000 that can be expensed for tax purposes at that time. The adoption of an automated machine means that we need to source additional inventories, hence net working capital adjustments of $15,000.

The corporate tax rate is 30%. Assume a cost of capital of 15% for discounting purposes.

Required:

a) Calculate the relevant cash flows either on an isolation or incremental basis. (15 marks)

b) Calculate the NPV and IRR of the project and advise whether the company should replace the manual machine. 5 MARKS