Capital Budgeting Analysis
You are required to work the following problem, using a discounted cash flow (NPV) analysis. You should model your answer on the text approach in Chapter 8.
“Gordon Hall is considering replacing an old machine with a new one from Li Ho. The old machine (bought 5 years ago from Tom Lee) cost $340,000, while the new one will cost $280,000, fully financed by a 5 year 9% per annum interest only loan.
“The new machine will be depreciated prime cost to $50,000 over its 5 year life. Gordon estimates that it will be worth $40,000 (salvage value) after 5 years. The old machine is being depreciated at prime cost to zero over its original expected life of 10 years. However, George can sell the old machine today for $86,000.
“The new machine will save Gordon $70,000 a year in cooling costs. Other costs are that, one year ago, a feasibility study on the new machine conducted for Gordon by an external firm of consultants, cost Gordon $20,000. With the new machine, Gordon will also lose $10,000 of sales of another product to Tom Lee.
“With the new machine, a one-off amount of cleaning supplies (current assets) at a cost of $9,000 will be required, and Henry estimates that accounts receivable (also current assets) will increase by $14,000. Both of these increases in working capital will be recouped at the end of the new machine’s life in five years time.
“Gordon’s cost of capital is 9%. The tax rate is 30%. Tax is paid in the year in which earnings are received.
(b) Should Henry purchase the new machine? State clearly why.”
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