Question

ASSIGNMENT

PNB Berhad is considering the purchase of a new production machine under its expansion programme. It costs RM500,000 and requires installation costs of RM50,000. The old stamping machine has zero terminal book value and five years of useful life remaining. It is being depreciated using the straight-line method. It was purchased five years ago for RM250,000, and can be sold today for RM100,000.

With the use of the new machine, sales in each of the next five years are expected to increase by RM250,000, and expenses (excluding depreciation) will represent 50% of sales. This new machine will not affect the company’s net working capital requirements. The new machine is estimated to have a useful life of five years with RM50,000 salvage value and will be depreciated using the straight-line method

The company is subject to a 25% tax rate and its cost of capital is 12%. The desired payback period is five years.

Required:

a) Determine the initial outlay and annual differential cash flows attributable to the new production machine.

b) Compute the following for the new machine:

i. Payback period

ii. Net present value

iii. Internal rate of return

c) Make a recommendation to accept or reject the new production machine. Justify your answer.

Answer 1

PNB is considering purchase of new machine and following are require criteria as mentioned below.

(a) Initial Outlay & Annual Differential Cash Flows:-

1. Initial Outlay is as under:-

Cost of New Machine (1)	500000
Installaton Cost of New Machine (2)	50,000
Sale Price of Old Asset (3)	100000
Initial Outlay	450000

2.Annual Differential Cash Flows to the new production mmachine is as under:-

Particulars	1	2	3	4	5	Sum
Incremental Sales (1)	250000	250000	250000	250000	250000	Annual Differential Cash Flows
Expenses excluding Deprecitaion(2)	125000	125000	125000	125000	125000
Cash Flow (3)=(1)-(2)	125000	125000	125000	125000	125000
Salvage Value (4)					50000
Net cash Flow (5)=(3)+(4)	125000	125000	125000	125000	175000	675000

(b) Computaion of Payback Period, NPV & IRR of New Machine

(1) Payback period is the time when initial outlay is nil

= Year 3 + ((Total Cash flow till year 3 - Initial Outlay)/( Total Cash flow till Year 3 - Total Cash Flow till year 4) * 1

= 3 + ((375000 - 450000)/375000 - 500000))*1

= 3.6 years

Note:- Please refer value of cash flows from Annual Differential cash Flow solutions mentioned above.

(2) Net Present Value is the differnce between initial Outlay & Net Present Cash Flows.

Year	Cash Fows	Depreciation	Net Cash Flows	Tax Rate @25%	Net Cash Flows after deducting Tax	Net Cash Flows including Depreciation	Cost of Capital	Present Value of Cash Flows
1	125000	100000	25000	6250	18750	118750	1.12	106026.8
2	125000	100000	25000	6250	18750	118750	1.25	94666.77
3	125000	100000	25000	6250	18750	118750	1.40	84523.9
4	125000	100000	25000	6250	18750	118750	1.57	75467.77
5	175000	100000	75000	18750	56250	156250	1.76	88660.45
Total	449345.7
Initial Outlay	450000
NPV	-654.319

Note:- Depreciation is calculated SLM basis.

(3) IRR is present stage where Present Value of Cash Flows is equal to Initial Outlay.

Calulating Cash Flows at 11% WACC.

Net Cash Flows including depreciation	Cost of Capital @ 11%	Present Value of Cash Flows
118750	1.11	106981.982
118750	1.23	96380.16
118750	1.37	86828.98
118750	1.52	78224.30
156250	1.69	92726.77
Total Present Value of CF	461142.20

IRR = 11% + (( Present Value of Cash Flows at 11% - Initial Outlay)/(Present Value of Cash Flows at 11%- Present Value of Cash Flows at 13%))

=11+((461142.20-450000)/(461142.20-449343.7))

=11.94437%

(c) Considering NPV of New Machine the proposal to be rejected on accurate basis but in order to maintain the goodwill and quality of items produced against minimal NPV loss one should opt for same considering long term approach.