SingTel Ltd. is an Australian operated company with mainly Singaporean resident
ID: 2648638 • Letter: S
Question
SingTel Ltd. is an Australian operated company with mainly Singaporean resident shareholders. The company is currently in the process of comparing two mutually exclusive machines for use in a new project with Machine A costing $30,000, having a useful life of five years and machine B costing $45,000 and having a useful life of 10 years.
Cash inflows from sales are expected to be $22,000 p.a. from each machine, while total cashbased operating costs are expected to be $10,000 and $8,000 respectively for each machine. All revenues and costs are assumed to occur at the end of the respective years for simplicity of assessment. Machine A is expected to have a salvage value of $4,000 at the end of 5 years, while at the end of 10 years machine B will be worthless. Depreciation for accounting and tax purposes is calculated on a straight-line basis on the original cost of each machine with no consideration in depreciation calculations for any expected salvage value.
The company has an aftertax required rate of return of 14% and pays income tax at the rate of 40% in the year following the year of income (that is, taxes levied on year 1 income are paid at the end of year 2).
a) Provide some reasons as to why the alternative machines are said to be mutually exclusive for the company.
b) Record the relevant cash-flows for each machine on a time (cash-flow) diagram.
c) Advise the company which machine (if any), should be purchased and justify all the processes you have used in order to reach your decision.
d) (i) Why is NPV considered to be the best method for capital budgeting? What does the NPV tell you?
(ii) When evaluating two mutually exclusive projects with unequal lives, is the project with the higher NPV better? Why or why not?
Explanation / Answer
a) the alternative Machines i.e. Machine A & B are said to be mutually exclusive for the company because
i) Both have different life
ii) Salvage value is different
iii) Yearly Income and operating expenses are also different.
iv) Depreciation of both the machines are not same.
c) Company should purchase machine B as it has more NPV, the cost of the machine will be recovered earlier & also the yearly cash flow is more.
d) i) NPV is considered to be the best method for capital budgeting because it shows the correct value of the cash flows. It gives the correct picture of the cash inflow and the cash outflow of each year.
d ii) When evaluating two mutually exclusive projects with unequal lives, yeas the project with higher NPV is better because as the Net Present Value is more it implies that the cash inflow is more & the payback period is less. Cost will be recovered in less time.
Particulars Machine A Total Machine B Total Initial Cost 30000 1 (30000) 45000 1 (45000) Sales 22000 3.43 75460 22000 5.21 114620 Operating Expense 10000 3.43 (34300) 8000 5.21 (41680) Salvage Value 4000 .519 2076 0 0 savings in tax because of dep 6000*35% 3.43 7203 4500*35% 5.21 8206 Total 20439/3.43 36146/5.21 NPV 5959 6938