Question

Space View Ltd. is a listed company on the Johannesburg Stock Exchange (JSE) that produces lenses and other optical equipment for a variety of telescopes. The company uses an outdated curve generator which it is determined to replace for strategic reasons, including that a more modern model that will enable them to manufacture a wider variety of lenses and reduce wastage. The current machine could be sold for R50 000 after originally having cost R500 000 and has a current book value of R0. It is estimated that the machine could have been sold for R10 000 if it was used for the coming five years. The company also expects to have to increase their outlay for working capital by R100 000.
The machine will be depreciated as follows:
Year 1 - 50%
Year 2 - 30%
Year 3 - 20%
Year 4 - 0%
Year 5 - 0%

It is expected that the curve generator will generate the following sales for the company:
Year 0 - 0
Year 1 - R900 000
Year 2 - R550 000
Year 3 - R400 000
Year 4 - R300 000
Year 5 - R100 000
The sales are estimated in today’s terms (Year zero terms) and must be adjusted for inflation using the nominal cash flow approach, the cash flows should be inflated, at a rate of 5% per annum. Variable costs amount to 20% of sales generated by the machine while associated fixed costs will amount to R50 000 per annum, fixed costs should also be adjusted for inflation as it is estimated in today’s terms.
The curve generator will cost R1100 000 and will require an installation cost of R200 000 to be considered in a working condition. The machine will be sold to a university for R300 000 (nominal amount) after five years.

The company is wholly financed through equity and has a beta of 1.20 associated with its shares, the risk-free rate is 4% and the market return is 8%. The project is considered in line with the normal risk profile of the company. Assume a tax rate of 28%.
a. Determine the relevant cash flows for the machine (13)
b. Calculate the discount rate (2)
c. Calculate the NPV of the machine (3)
d. State whether the machine should be accepted or rejected (1)
e. Briefly, discuss how different the NPV would have been if the inflation rate had been lower than 5% (4)

Answer 1