QUESTION ONE

Katemba Engineering Limited is a copperbelt province based company. It is considering replacement of an existing machine with a new higher capacity machine. The new machine will cost K672,000. If the new machine is purchased, annual operating cash flows are expected to increase from K210,000 to K378,000. The new machine is planned to have an economic life of five years with end of life scrap value of K147,000. Katemba uses a cost of capital of 11 percent. If the new machine is not purchased, the existing machine is expected to have another five years of useful life with zero end-of-life net scrap value. The current book value of the existing machine is K126,000 but its current scrap value on the secondhand market is K77,000. Assume that the scrap value can be realized immediately and is costless. Ignoring tax considerations;

Calculate the project net cash flow to Katemba Engineering over the next five years if the existing machine is retained. (4 marks)

Calculate the project net cash flow to Katemba Engineering over the next five years if the new machine is purchased. (5 marks)

Using the Net Present Value of capital budgeting, should Katemba engineering purchase the new machine? Justify your answer. (10 marks)

What are some of the challenges that the NPV might present to Katemba Engineering as a method of project evaluation? What alternative method can they employ under these circumstances? (6 marks)