Capital Budgeting Analysis

You are required to work the following problem, using a discounted cash flow (NPV) analysis. You should model your answer on the text approach in Chapter 8.

“Gordon Hall is considering replacing an old machine with a new one from Li Ho. The old machine (bought 5 years ago from Tom Lee) cost $340,000, while the new one will cost $280,000, fully financed by a 5 year 9% per annum interest only loan.

“The new machine will be depreciated prime cost to $50,000 over its 5 year life. Gordon estimates that it will be worth $40,000 (salvage value) after 5 years. The old machine is being depreciated at prime cost to zero over its original expected life of 10 years. However, George can sell the old machine today for $86,000.

“The new machine will save Gordon $70,000 a year in cooling costs. Other costs are that, one year ago, a feasibility study on the new machine conducted for Gordon by an external firm of consultants, cost Gordon $20,000. With the new machine, Gordon will also lose $10,000 of sales of another product to Tom Lee.

“With the new machine, a one-off amount of cleaning supplies (current assets) at a cost of $9,000 will be required, and Henry estimates that accounts receivable (also current assets) will increase by $14,000. Both of these increases in working capital will be recouped at the end of the new machine’s life in five years time.

“Gordon’s cost of capital is 9%. The tax rate is 30%. Tax is paid in the year in which earnings are received.

“REQUIRED.

(a) Calculate the net present value of the proposed change, that is, the net benefit or net loss in present value terms of the proposed changeover.

(b) Should Henry purchase the new machine? State clearly why.”