## (solution) Question A manufacturing company is considering replacing an old

Question

A manufacturing company is considering replacing an old machine with a new one. The risk-free rate of return is given as 4% p.a. The yearly return for the share market is given as 12%. Suppose a listed company has a beta value of 0.75. The shareholders of the company cannot benefit from imputation credits. The old machine was purchased 5 years ago for \$100,000 and is expected to have a useful life of 10 years and zero salvage value. If the company sold the old machine today, it would receive \$40,000. The new machine will cost \$75,000 and is expected to have a useful life of 5 years with zero salvage value. The old machine has maintenance costs of \$10,000 per year whereas the new machine has maintenance costs of \$1,000 per year. The new machine will also reduce the cost of defects from \$5,000 per year to \$1,000 per year. The company uses straight-line depreciation, and assumes a company tax rate of 30%.

• a) What is the investors? required rate of return for the company?s shares?
• b) If the company is either a taxation category 1 or a taxation category 2 company, to which taxation category does the company belong. Would capital budgeting for the company be performed on a before-tax or an after-tax basis?
• c) If the old machine were sold today identify the annual depreciation expense and the tax savings for the old machine.

• d) Calculate the initial outlay for the project.

• e) Calculate the annual depreciation expense for the new machine and determine the net cash flows for years 1-5 of the project.

• f) Discuss what the payback period identifies and therefore why it is readily used.

• g) Calculate the payback period. What are the weaknesses of the payback period method for evaluating projects?

• h) Calculate the net present value (NPV), profitability index (PI) and internal rate of return (IRR) of the project.

a 10% b

It would be done on the after tax basis for cash flows.

c

Annual Depreciation \$ 10,000 Loss on Machine

Tax saving when sold \$ 10000

3,000 d

Initial outlay \$ 38,000 e

Annual Depreciation \$...

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