Question

4.1 Itata Limited has the choice of purchasing one of two machines viz. Machine L or Machine T. Both machines have a five-year life. The annual revenues from each machine are estimated at R2 000 000. Machine L is not expected to have a scrap value. Machine L costs R4 500 000. Its annual cash operating costs are estimated at R680 000. Machine T costs R4 500 000. Its annual cash operating costs are estimated at R700 000. The scrap value of this machine is estimated to be R200 000. Depreciation amounts to R900 000 per year for Machine L and R860 000 for Machine T. The cost of capital may be assumed to be 14%. Required: 4.1.1 Calculate the Payback Period of Machine L (answer expressed in years, months and days). (3) 4.1.2 Use the Net Present Value technique to determine the machine that should be selected by Itata Limited. (7) 4.1.3 Calculate the Accounting Rate of Return of Machine L (answer expressed to two decimal places). (5)v

Answer 1

1. Pay Back period means the Time taken to recover initial investment of a project through it's cash inflow

Formula= Initial investment/ Net cash flow per period

Machine L

Initial Investment = 45,00,000

Cash Outflow = Annual Cash Operating Expenses = 6,80,000

Cash Inflow = 20,00000

Net Cash Flow per year = Cash inflow minus cash outflow

= 20,00,000-6,80,000

=13,20,000

* Please note thta we haven't include depreciation as a cash outflow as depreciation is a non cash expense and should be avoided while calculating pay back period, Also Note that there is no scrap value for Machine L

Payback period = 4500000/1320000 = 3.41 Years or 3 Year 4 Months 27 days

Machine T

Initial Investment = 45,00,000

Scrap Value= 200000

Net Investment= 4500000-2000000= 43,000000

Cash Outflow = Annual Cash Operating Expenses = 700 000

Cash Inflow = 20,00000

Net Cash Flow per year = Cash inflow minus cash outflow

20,00000-700,000= 13,00,000

Payback period = 4300000/13000000 = 3.31 Years or 3 Year 3 Months 22 days

*Note that scrap value should be included for machine T as it is an income after the machines useful life

Considering both machines we can see that machine T have a smaller payback period compared to machine L, hence we can choose machine T

3.

ARR for Machine L

Accounting Rate of Return = Average annual accounting profit /Initial investment*100%

Net profit of machine L =Annual Revenue -(Operating expenses + Depreciation)

= 2000,000-(680,000+900,000)

=2,000,000-1,580,000=420,000 per year

ARR= (420,000/4,500,000)×100= 9.33%