Question
With the vision to expand market to New South Wales in near future, the headquarter of QV wants to increase SWs capacity to at least
With the vision to expand market to New South Wales in near future, the headquarter of QV wants to increase SWs capacity to at least double the current level. There are two proposals coming from the factory manager:
(1) Keep the old machine, and purchase another machine of the same type, which has the same capacity as the old machine, 150,000 kg per year.
(2) Sell the old machine and purchase a new advanced machine, which has the capacity to produce 600,000kg per year. To purchase this advanced machine, which will cost $2 million, QV will need to spend $1.5 million out of their own fund, and the remainder will be funded by a 10-year external loan of $500,000 at 6% per year. Interest is to be paid yearly and principle to be paid off at the end of the loan term.
The manager, which has some accounting knowledge, has estimated the cashflows associated with two options in the below table. The increases in sale are estimated based on the additional production output under each option, and at current selling price. The increases in variable costs are based on the additional production output and standard variable cost per unit.
Forecasted cashflows | Option 1 | Option 2 | |||
Cost of new machine | $ 500,000 | $ 2,000,000 | |||
Sales of old machine netbook value of $150,000 | $ 100,000 | ||||
Annual increase in sales | $ 2,500,000 | $ 4,250,000 | |||
Annual increase in variable costs | $ 1,630,000 | $ 2,716,667 | |||
Interest expense yearly | $ 30,000 | ||||
Paid off principle at the end of year 10 | $ 500,000 | ||||
Expected sales of machines at the end of useful life | $ 10,000 | $ 50,000 | |||
Tax rate | 30% | 30% | |||
Weighted average cost of capital | 6% | 6% | |||
Depreciation method | straight-line | straight-line | |||
Useful life (years) | 10 | 15 | |||
Requirement 1: Make recommendation to the manager as to which option to be selected by undertaking the following: | |||||
(a) Calculating after tax NPV for both options (12 marks) | |||||
(b) Identify and explain other possible cashflows that might not be considered by the manager (2 marks) | |||||
Requirement 2: Assess the accuracy of the NPV for both projects in light of the current COVID-19 situation (5 marks) |
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