Question

Haw Par Industries (HPI) is a major supplier of herbs to all Chinese Medical Halls in the country. It needs to purchase a new fully automated process line costing RM900,000.00. Modification to the equipment, shipping and freight insurance will costs another RM200,000.00. This proposed new equipment will be depreciated using straight-line depreciation towards an estimated RM100,000.00 salvage value over its 4-year project life.

If the proposed new equipment are purchased, it will replace the existing one purchased 4 years ago at an installed cost of RM400,000.00. The existing equipment, depreciated on a straight-line basis towards zero salvage value, will be worthless at the end of its 8 years useful life, but can be sold today for RM210,000.00.

HPI expects to increase its sales by RM345,000.00 but operating expenses will also increase by RM28,000.00. The increase in sales and operating expenses are expected to be constant during its project life. Net operating working capital is also expected to increase by RM35,000.00. This investment is expected to be fully recovered at the end of its project life.

HPI has already spent RM50,000.00 on consultancy work to conform with the requirements set by the Environmental Agency. The company cost of capital is 10% and is in the 30% tax bracket.

a) Should HPI proceed with the replacement? [Hint: Use the NPV & IRR criteria in your decision making]

b) What does it mean that only relevant cash flows should be included estimating cash flows? Explain your answer based on the information available in the above question and demonstrate with examples.

Answer 1

a) NPV & IRR :
Year	Cash flow	Dep	IBT	IAT	Cash flow	Discount 10%	PV	DIS 11%	PV 11%
0	-1150000		210000	147000	-1003000	1	-1003000
0	-35000				-35000	1	-35000
1	317000	262500	54500	38150	300650	0.909	273290.9	0.901	270885.7
2	317000	262500	54500	38150	300650	0.826	248336.9	0.812	244127.8
3	317000	262500	54500	38150	300650	0.751	225788.2	0.731	219775.2
4	317000	262500	54500	38150	300650	0.683	205344	0.659	198128.4
working capi				35000	35000	0.683	23905	0.659	23065
salvage			100000	70000	70000	0.683	47810	0.659	46130
NPV							-13525.1
PV for IRR							1024475		1002112
IRR = 10% + (1024475-1038000)/(1024475-1002112) (11-10)%
IRR = 10% + (-0.6)%
IRR = 9.4%
BECAUSE THE NPV IS IN NEGATIVE AND PROJECT IS BELOW COST OF CAPITAL AT 9.4%
SO THE HPI SHOULD NOT PROCEED WITH THE REPLACEMENT.
b) We have to consider only the relevant cash flows as investment decisions
are based on all cash inflows during the project and not before and after
the projects cash flows. As in the problem disposal of old equipment save borrowing
for the new equipment and increase in sales will reimburse the cash expensed on new
equipment. Other cash flows beyond the project period of no use to the Project's decision
making.