Question

1. Your company needs a new machine. Two companies are selling this machine in the market, their conditions are as below

Company A: The purchase of the new machine at a cost of £15,000. The purchase price includes maintenance for the first two years, but after that maintenance will cost £1,050 a year (payable at the end of each year).

The machine will have a useful life of five years, after which time it is estimated that it will have a scrap value of £4,000.

The expected income from the machine will be £1,500 at the end of the first year, £2,500 end of the second year, £3,500 end of the third year, £4,500 at the end of the fourth year, and £5,500 at the end of the fifth year.

Company B: The purchase of the new machine at a cost of £10,000. The purchase price includes maintenance for the first year, but after that maintenance will cost £1,000 a year (payable at the beginning of each year).

The machine will have a useful life of five years, after which time it is estimated that it will have a scrap value of £1,500.

The expected income from the machine will be £1000 at the end of the first year, £3000 each year at the end of the second, third and fourth years, and £5000 at the end of the fifth year

Assuming the discount rate is 4%, write a brief report advising the company on which contract will be more profitable and so whether it should accepted. Remember to take all costs and cash availability into consideration. Show any calculations you make in support of your recommendation. (14 points, no more than 500 words)

3. How confident are you about your advice and under what circumstances might it change? (5 points, no more than 100 words)

Answer 1

Part 1:

Calculation of Net present value for purchase of machine from Company A:

(Outflows are shown as negative and inflows as positive)

							figures in £
At the end of Year	Purchase cost of machine	Maintenance cost	Scrap value	Expected income	Net Cash inflow / Outflow	Discount factor @ 4% rate	Present value
0	(15,000.00)	-	-	-	(15,000.00)	1.0000	(15,000.00)
1	-	-	-	1,500.00	1,500.00	0.9615	1,442.25
2	-	-	-	2,500.00	2,500.00	0.9246	2,311.50
3	-	(1,050.00)	-	3,500.00	2,450.00	0.8890	2,178.05
4	-	(1,050.00)	-	4,500.00	3,450.00	0.8548	2,949.06
5	-	(1,050.00)	4,000.00	5,500.00	8,450.00	0.8219	6,945.06
						NPV	825.91

Calculation of Net present value for purchase of machine from Company B:

(Outflows are shown as negative and inflows as positive)

							figures in £
At the end of Year	Purchase cost of machine	Maintenance cost	Scrap value	Expected income	Net Cash inflow / Outflow	Discount factor @ 4% rate	Present value
0	(10,000.00)	-	-	-	(10,000.00)	1.0000	(10,000.00)
1	-	(1,000.00)	-	1,000.00	-	0.9615	-
2	-	(1,000.00)	-	3,000.00	2,000.00	0.9246	1,849.20
3	-	(1,000.00)	-	3,000.00	2,000.00	0.8890	1,778.00
4	-	(1,000.00)	-	3,000.00	2,000.00	0.8548	1,709.60
5	-	-	1,500.00	5,000.00	6,500.00	0.8219	5,342.35
						NPV	679.15

Note: Since maintenance cost is incurred at the beginning of each year, the cost for 2nd year is shown as being incurred at the end of 1st year and so on.

Hence, contract with Company A is more profitable as the NPV is higher if the machine is purchased from Company A.

Part 2:

The circumstances under which the advice may change are:

a. Negotiating a better price for the machines.

b. Saving in maintenance costs.

c. Changes in scrap value.

d. Changes in expected income and also the distribution of such income over the years.

e. Changes in cost of capital of the Company or the discount rate.