Question

Question 1: Capital Budgeting       

Monash Manufacturing Ltd is contemplating the purchase of a new fully automated machine to replace the old manually operated machine that has been operating in the factory for the last 6 years. The machine manufactures disk drives. When the new machine replaces the old machine, the old machine will be sold immediately (i.e. today). Both machines are fully depreciated over their expected lives using straight-line depreciation to a book value of zero. The new machine will also be sold at the end of its useful life. In addition, because the new machine will work faster than the old one, investment in raw materials and goods-in-progress inventories will increase by $5,000 initially (today), there are no further increases in inventory in years 1, 2 and 3 and the company will recover the initial additional $5,000 inventory outlay at the end of year 4. Revenues from the new machine will stay the same but the new machine will reduce maintenance costs by $16,000 per year. Because of the new machine, the company will need to pay an extra $16,000 in interest expense every year. Maintenance workers need special training to use the new machine because the new machine involves recent IT technology advancements. However, the company purchased a similar machine 5 months ago and at that time spent $12,000 training workers and workers need no further additional training to use the new machine. The cost of equity capital of the firm is 24% per annum and the weighted average cost of capital (WACC) of the firm is 20% per annum. The company’s marginal corporate tax rate is 30%. Information regarding the old machine and the purchase of the new machine is given in the table below.

	Old Machine	New Machine
Purchase price ($)	25,000	60,000
Estimated life of machine (years)	6	4
Machine sales proceeds ($)	16,000	20,000
Annual maintenance costs ($)	27,000	11,000

1. What discount rate should Monash Manufacturing use to value this project? What assumption have you made about the risk of the project’s incremental cashflows?

2. Using the table provided below, identify the project’s incremental free cash flows. Be careful to clearly label the project’s (i) initial investment (t=0), (ii) operating free cash flows (t=1 to 3) and (iii) terminal free cash flow (t=4).

Description	Year 0	Year 1 – 3 (each year)	Year 4
Incremental Free Cash Flows

3. Do you recommend accepting or rejecting the decision to replace the old manually operated machine with the new fully automated machine? To obtain full credit you are required to justify your recommendation using appropriate capital budgeting decision techniques.

(Please ensure that you show all working, you can insert a scan or photograph of handwritten workings if you wish).

4. Monash Manufacturing has an independent computer replacement project with conventional cashflows. The project’s cashflows have more exposure to market risk than the cashflows of Monash Manufacturing’s average risk project. The net present value (NPV) of the computer replacement project is zero when discounted at 20%.   Determine whether Monash Manufacturing should accept or reject the computer replacement project. Justify your answer.

Answer 1

The above project should not be accepted because new machine will give negative Incremental cashflows.