Question

Footer Inc: Replacing the broken Machine

Footer Inc, a manufacturer of T-shirts, had seen its production line slow to a halt when one of the company’s twomachines had broken down. If capacity increased, estimated sales revenues would rise by at least $50,000 per month due to unmet demand and increased efficiency. COGS on the additional revenues were expected to be 65% monthly. The company’s management, saw 2 viable options to increase capacity:

OPTION 1: PURCHASE A NEW MACHINE

The cost of the new machine would be $142,000. Also there would be operating costs of $140,000 per month. These include $20.000 depreciation. After five years, the machine would have a salvage value of $40,000. Cost of capital is 6%.

OPTION 2: PURCHASE A SECOND HAND MACHINE

The company selling the machine also offers second hands machines. The cost of a second hand machine would be $60,000. Useful life three years. After three years the machine would have a salvage value of $40.000. The operating costs and cost of capital are the same as option 1.

REQUIRED

1. Use NPV and PP calculations to analyze each option. (start with identifying the cash inflows and cash outflows). USE THE XL-SHEET PROVIDED

2. Make a well-reasoned recommendation for the company’s management backed up by your analysis. c.a. 100 words TYPE YOUR ANSWER IN THE XL SHEET PROVIDED

3. After acquiring the machine, Footer Inc decided to grow its business and open an additional plant. In order to finance this, the company issued 4 million ordinary shares at market value $1,0 and took a bank loan of $2 million at an interest rate of 10%. The required rate of return by investors is 15%. Tax rate is 30%. Calculate the WACC. TYPE YOUR ANSWER IN THE XL SHEET PROVIDED

Answer 1

Since the life under both the options is different, we will use Annual Capital Charge(ACC) method and the option with minimum ACC will be selected. The sales revenue and COGS will be same under both the options. Hence, will be irrelevant for decision making and not considered.