Question

. Sure-cure pharmaceutical Co Ltd. is contemplating investing in a machine for its manufacturing processes. The machine will be used to manufacture a product known as “Curex”. The machine will cost Sh.5 million and will incur installation costs amounting to Sh.500,000. The machine is expected to have an economic life of 5 years and a re-sale value of Sh.1 million at the end of this period.

The acquisition of this machine is expected to cause in working capital to increase by Kshs 2.5 Million at the beginning of the economic life of the machine. The net change in working capital will be recovered at the end of the machine’s economic life.

The quantity of “Curex” expected to be manufactured and sold in each year will be as follows:

Year	1	2	3	4	5
Quantity manufactured and sold (units)	20,000	15,000	10,000	12,000	14,000

            Additional information:

1. Each unit of “Curex” is expected to be sold at Sh.100 in year However, the price is expected to increase by 10% annually thereafter.
2. The variable cost per unit of “Curex” is estimated at Sh.20 in year 1. In subsequent years, this cost will rise at the same rate as the increase in the selling price.
3. Fixed costs per annum excluding depreciation are estimated at sh.0.5 million.
4. The company applies the straight line method of depreciation for all its fixed assets.
5. The company’s cost of capital is 12%.
6. Corporation tax rate is 30%.

Required:

Using the net present value (NPV) technique, advise the company on whether the machine should be purchased.                                                                                                      

Answer 1

The calculation for NPV is given below :

The workings are :

Sure-cure pharmaceutical Co Ltd should not purchase the machine as it has a negative NPV of Sh.2,863,728

The same calculations with Excel formulas shown :