Question

Last year, Bryce Canola Oil Company paid a consultant $12,000 to conduct an analysis on how to improve its operations. One outcome of this, resulted in a recommendation by the consultant, to consider the replacement of its operating equipment.

The company now plans to replace its old harvester machine with a new one, to speed up its production process. The machine will cost the company $1 million, inclusive of delivery and set-up charges. The machine can be depreciated on a straight-line basis over five years. This capital expenditure qualifies for the recently announced 4% investment allowance for agribusiness, by the Federal Government.

If the company proceeds with the replacement, the old harvester machine will be sold today, for $180,000. It hasn’t been fully depreciated, and currently has a book value of $200,000.

The new harvester will speed up production in the canola fields by 50%, and the company expects revenues to increase from $1.2 million per year to $2.1 million per year. However, expanded production will increase operating costs by $440,000 each year. The new harvester will have to be insured at an additional cost of $25,000 per year, where insurance premiums are paid at the start of each year. At the end of five years, the company expects to sell the new harvester for a salvage value of $290,000. The company will incur a new bank loan to fund this purchase and the lender has indicated an interest rate of 7.5% p.a. The company’s tax rate is 30%. The firm typically applies an after-tax required rate of return based on its WACC for routine equipment replacement proposals. This rate will be 9% p.a., considering the impact of the new bank loan. The company also typically prefers projects that take less than 2 years to recover the initial investment.

Tasks

• Set up a table of incremental cash flows over the useful life of this machine.
• Calculate the Net Present Value (NPV), Internal Rate of Return (IRR), the Profitability Index (PI) and the Payback Period for this investment proposal.   

Answer 1

Based on the given data, pls find below calculations:

The Payback period is more that 2 years for this Project; However, the NPV is postive and the project is recommended for investment;