Angel company ltd is appraising the purchase of a new machine, costing $1·5 mill
ID: 2721625 • Letter: A
Question
Angel company ltd is appraising the purchase of a new machine, costing $1·5 million, to replace an existing machine which is becoming out of date and which has no resale value. The forecast levels of production and sales for the goods produced by the new machine, which has a maximum capacity of 400,000 units per year, are as follows: Year 1 2 3 4 Sales volume (units/year) 350,000 380,000 400,000 400,000 The new machine will incur fixed annual maintenance costs of $145,000 per year. Variable costs are expected to be $3·00 per unit and selling price is expected to be $5·65 per unit. These costs and selling price estimates are in current price terms and do not take account of general inflation, which is forecast to be 4·7% per year. It is expected that the new machine will need replacing in four years’ time due to advances in technology. The resale value of the new machine is expected to be $200,000 at that time, in future value terms. The purchase price of the new machine is payable at the start of the first year of the four-year life of the machine. Working capital investment of $150,000 will already exist at the start of the four-year period, due to the operation of the existing machine. This investment in working capital is expected to increase in nominal terms in line with the general rate of inflation. Angel company ltd pays corporation tax one year in arrears at an annual rate of 27% and can claim 25% reducing balance tax-allowable depreciation on the purchase price of the new machine. The company has a real after-tax weighted average cost of capital of 6% and a nominal after-tax weighted average cost of capital of 11%. Required: i. Using a nominal terms net present value approach, evaluate whether purchasing the new machine is financially acceptable ii. Discuss the reasons why investment finance may be limited, even when a company has attractive investment opportunities available to it.
Explanation / Answer
Statement of Operating cash Flows
Note: Selling Prise, variable cost and fixed cost for year 2,3, 4 are adjusted using inflation rate.
Statement of Net Present Value / NPV
1546033
Net Present value of the new machine is $1,546,033, so it should be purchased.
Note: Working capital cash flow is not a part of deciding factor as it is not increased or decreased with new investment decision.
Depreciation Schedule Year Beginning balance Depreciation Ending balance i ii iii iv 1 1500000 375000 1125000 2 1125000 281250 843750 3 843750 210938 632813 4 632813 158203 474609