Question

The management of Lota Ltd used discounted cash-flow techniques to

evaluate capital expenditure projects. They recognise that budgeting several years ahead is subject to estimating probabilities. They therefore estimate not only the likely cash- flows but also the probabilities of different cash-flows.

They are contemplating the acquisition of a machine at a cost of R234 000.

The probabilities of its life expectancy are as follows:

10 years 0.2

11 years 0.5

12 years 0.3

For a premium which will be payable in addition to the purchase price, the supplier of the machine is prepared to guarantee that the machine will last at least 11 years.

The machine produces a single product with a selling price of R12 per unit and variable cost of production of R7 per unit.

The probabilities of the following production volumes are:

5000 units per annum0.1

6000 units per annum0.3

7000 units per annum0.6

The present value of R1 per annum at the company's screening rate for capital projects is as follows:

10yearsR6.71

11yearsR7.13

12yearsR7.52

Required:

a)Advise the management of Lota Ltd on whether they should acquire the machine (14)

b)Calculate how much Lota Ltd can afford to pay by way of a premium in the first year for a guarantee that the machine will last 11 years.(6)