XYZ Limited is a producer of concrete blocks and other building supplies in Australia.

Increased growth in annual sales has allowed the company to branch out in terms of products

and geographic sales area. The company currently has a sales turnover of over $$10$ million with

profits in excess of $$1$ million.

A capital budgeting meeting is held to consider the replacement of current concrete block

moulding machines. The machines currently in use were acquired $8$ years ago at a cost of $$2\mathrm{.}6$

million. They have an expected life of $10$ years and are being depreciated for tax purposes at

$10\%$ per annum on the straight$-$line basis. Operating costs have risen steeply as the machines

have aged, and in the forthcoming year are expected to be about $$600,000.$ If the current

machines are scrapped now, they would fetch a price of $$300,000.$ They would worth probably

only $$100,000$ if they are held for another year.

The chief engineer of XYZ limited$,$ argues the current machines are badly in need of an

overhaul to eliminate further increase in operating costs. The finance director, Mr Williams,

has just been presented with a proposal, which would require a total expenditure of $$550,000$

to restore the current machines to their optimal condition. The current machines, even if

overhauled, could probably last only $4$ years. At that point, they would be worth only the scrap

value of about $$100,000.$

There is no question that the current machines need new engine and general overhaul soon.

However, Mr William feels it unwise to proceed without also considering the purchase of new

machines. ABC Limited has approached XYZ with two new designs of moulding machines

which incorporated extensively automated control systems. Relevant information about the two

machines is given below.

Details of the alternatives:

The first alternative is the Superior machines, which cost a total of $$1\mathrm{.}2$ million and have an

expected useful life of $4$ years, at which point they could probably be sold for $$100,000.$ Use

of the Superior machines would result in cost savings of $$200,000$ per year in comparison with

the machines currently in use.

The second alternative, the Elite machines, would cost $$1\mathrm{.}5$ million with a total shipping and

installation fees of $$10,000$ and $$20,000,$ respectively. They have an expected useful life of $6$

years and their scrap value after $6$ years is estimated to be at $$200,000.$ Annual cost savings

would amount to $$180,000.$

Both the new machines should be able to handle a larger production loads, and this might

generate additional revenues, net of additional out$-$of$-$pocket costs, of as much as $$100,000$ per

year. The workers would require additional training to handle the new machine$$s more complex

and sophisticated equipment, and this would probably require an expenditure of $$50,000.$ In

addition, since the new machines are more efficient, they will require an immediate increase in

raw materials and work in progress inventory of $$20,000.$ This increase in working capital is a

result of the efficiency of the new machines and, as such, can be eliminated when the new

machines terminate. For both the machines, the depreciation rate allowed by the tax authorities

is $30\%,$ either on a straight$-$line basis or reducing balance basis.

The appropriate, after$-$tax, cost of capital $($discount rate$)$ for the project is considered to be $12\%.$

This is same as the company$$s after$-$tax weighted average cost of capital. Assume that the

company is subject to $30\%$ corporate tax and that the tax is paid at end of the same year $($i$.$e$.,$

not the following year

$1.$ Prepare cash flow tables $($which incorporates taxes and includes initial investment,

operating and terminal cash flows$)$ using the information given in the case. The

incremental cash flows are to be prepared to decide the following alternatives:

$($a$)$ to overhaul the old machines now, or

$($b$)$ to buy the new machines now $$ which machine, Superior or Elite?

$[$Hint: Assume all overhaul expenses qualify for depreciation$]$

$2.$ Clearly state and justify the assumptions and the qualitative factors considered in arriving

at the above decisions?

$[10$ marks$]$

$3.$ It is necessary to check if the project made financial sense before it is accepted. Based

on the cash flow table derived in Question $1,$ conduct a sensitivity analysis of NPVs to

change in operating costs, working capital, and applicable discount rate individually.

Assume each of these variables can deviate from its estimated value by plus or minus

$15\%.$

$[$Hint: Provide the answers to this question even if your decision is to reject the project.$]$

$[30$ marks$]$

$4.$ Consider all information given in the case study and the results derived in Questions $1$ to

$3.$ Advise the executive committee on whether they should invest in alternative $($a$)$ or

alternative $($b$)$ of Question $1.$ Discuss the reasons for your recommendation and the issues

the XYZ Company needs to take into account given this advice