Question

Baraka Ltd. is considering investing in a new processing machine costing a. Sh25 million. The machine would be used for five years and thereafter be disposed off for Sh. 5 million at the end of the fifth year. The following additional information is available:

i. Additional raw materials amounting to Sh5 million would be required 1. at the beginning of the five-year period. This would increase accounts payable by Sh2 million. These changes in working capital would reverse at the end of the fifth year.

ii. The new machine would increase the company’s annual gross profit from Sh12 million to Sh24 million.

iii. Incremental fixed costs would amount to Shs. 2,200,000 per annum.

iv. Additional machine operators would be employed at a cost of Shs. 1,600,000 per annum.

v. The new machine would be depreciated on a straight-line basis.

vi. The cost of capital is 12%.

vii. The corporation rate of tax is 30%.

Required: Using the net present value (NPV) method, advice the company on whether to invest in the new machine

Answer 1

Based on the given data, pls find below steps, workings and answer NPV highlighted in yellow:

The NPV of the Project is positive Sh 1786854.27 and is recommended for investment in to New Machine.

Computation of Net Present Value (NPV) based on the Discounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) ; Year 2 = Year 1 factor/(1+discounting factor %) and so on;

Next, the cashflows need to be multiplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;