Question

1. Altima Ltd, a manufacturer of edible oils, is contemplating the purchase b. of a new oil processing machine to replace the existing one. The existing machine was acquired two years ago at a cost of Shs.4,000,000. The useful life of this machine was originally expected to be five years with no salvage value, but after a critical analysis, the financial analyst has now estimated that the machine will have an economic life of 10 years with a salvage value of Shs.500,000.

The new machine is estimated to cost Shs.8,000,000 and Sh400,000 would be incurred in installing the machine. The new machine is estimated to have a useful life of 10 years. An expert in asset valuation estimates that the existing machine can be sold at Shs. 2,500,000 in the open market. The new machine is expected to lead to increased sales. To support the increased sales, debtors would increase by Shs. 320,000, stock by Shs.140,000 and creditors by Shs. 300,000.

The estimated profit before depreciation and tax over the next 10 years for the two machines is as given below:

Year	New Machine Shs.	Old Machine Shs
1	350,000	280,000
2	400,000	300,000
3	420,000	320,000
4	410,000	340,000
5	410,000	340,000
6	380,000	320,000
7	380,000	310,000
8	350,000	280,000
9	300,000	260,000
10	280,000	240,000

The company’s cost of capital is 10%. Corporation tax applicable is 30%. The company uses the straight line method of depreciation.

Required

1. Initial investment required for replacement of the old machine.
2. An evaluation of whether it is worthwhile to undertake the replacement ii. of the machine.

Answer 1

Q i) Initial investment = Cost of new machine + installation cost + working capital - after tax sale price of old machine

= 8,000,000 + 400,000 + (320,000 + 140,000 - 300,000) - 2,500,000 (1-0.30)

= 8,400,000 + 160,000 - 2,500,000 (0.70)

= 8,560,000 - 1,750,000

= 6,810,000

Q ii) Cash flow of new machine and npv

Years	EBITDA	(-)Depreciation	EBT	(+)Tax savings	Net Profit	(+)Depreciation	Cashflow
1	350,000	(840,000)	(490,000)	147,000	(343,000)	840,000	497,000
2	400,000	(840,000)	(440,000)	132,000	(308,000)	840,000	532,000
3	420,000	(840,000)	(420,000)	126,000	(294,000)	840,000	546,000
4	410,000	(840,000)	(430,000)	129,000	(301,000)	840,000	539,000
5	410,000	(840,000)	(430,000)	129,000	(301,000)	840,000	539,000
6	380,000	(840,000)	(460,000)	138,000	(322,000)	840,000	518,000
7	380,000	(840,000)	(460,000)	138,000	(322,000)	840,000	518,000
8	350,000	(840,000)	(490,000)	147,000	(343,000)	840,000	497,000
9	300,000	(840,000)	(540,000)	162,000	(378,000)	840,000	462,000
10	280,000	(840,000)	(560,000)	168,000	(392,000)	840,000	448,000

Working notes:-

Depreciation= 8,400,000 / 10 = 840,000

Using financial calculator to calculate NPV

Inputs: C0= -6,810,000

   C1= 497,000 frequency=1

C2= 532,000. frequency= 1

   C3= 546,000. Frequency= 1

   C4= 539,000. Frequency= 2

   C5= 518,000. Frequency= 2

C6= 497,000. Frequency= 1

C7= 462,000. Frequency= 1

C8= 448,000. Frequency= 1

I= 10%

Npv= compute

We get, Npv of the new machine as -3,646,749.61

Cash flow of old machine and Npv

Years	EBITDA	(-)Depreciation	EBT	(+)Tax Savings	Net profit	(+)Depreciation	Cashflow
1	280,000	(350,000)	(70,000)	21,000	(49,000)	350,000	301,000
2	300,000	(350,000)	(50,000)	15,000	(35,000)	350,000	315,000
3	320,000	(350,000)	(30,000)	9,000	(21,000)	350,000	329,000
4	340,000	(350,000)	(10,000)	3,000	(7,000)	350,000	347,000
5	340,000	(350,000)	(10,000)	3,000	(7,000)	350,000	347,000
6	320,000	(350,000)	(30,000)	9,000	(21,000)	350,000	329,000
7	310,000	(350,000)	(40,000)	12,000	(28,000)	350,000	322,000
8	280,000	(350,000)	(70,000)	21,000	(49,000)	350,000	301,000
9	260,000	(350,000)	(90,000)	27,000	(63,000)	350,000	287,000
10	240,000	(350,000)	(110,000)	33,000	(77,000)	350,000	273,000

Working note:-

Depreciation= 4,000,000 - 500,000 / 10

= 3,500,000 / 10

= 350,000

Using financial calculator to calculate the Npv

Inputs: C0= -4,000,000

C1= 301,000. Frequency= 1

C2= 315,000. Frequency= 1

C3= 329,000. Frequency= 1

C4= 347,000. Frequency= 2

C5= 329,000. Frequency= 1

C6= 322,000. Frequency= 1

C7= 301,000. Frequency= 1

C8= 287,000. Frequency= 1

C9= 273,000. Frequency= 1

I= 10%

Npv= compute

We get, Npv of old machine as -2,048,048.23

As the Npv of the new machine is more negative than old machine , we shiuld not replace it.