Posted: March 23rd, 2017

Estate Developers purchased a machine five years ago at a cost of £7,500. The machine had an expected economic life of 15 years at the time of purchase and a zero estimated salvage value at the end of 15 years. It is being depreciated on a straight line basis and currently has a book value of £5,000. The Financial Manager has conducted a feasibility study aimed at acquiring a new machine for £12,000 and is depreciated over its 10 years useful life. The new machine will expand sales from £10,000 to £11,000 per annum and will reduce labor and materials usage sufficiently to cut operating cost from £7,000 to £5,000. The salvage value of the new machine is £2,000 at the end of useful life. The current market value of the old machine is £1,000 and tax is 40%. The firms cost of capital is 10%. The financial manager wishes to make a decision on whether to replace the old machine with a new one and he seeks your held.

N.B. The decision to replace takes into account the following:

- a) Estimate the actual cash outlay attributable to the new machine
- b) Determine the incremental cash flows.
- c) Compute the NPV of incremental cash flows.
- d) Add up the present value of the expected salvage value to the P.V. of the incremental cash flow.
- e) Ascertain whether the NPV (net present value) is positive or whether the IRR (internal rate of return) exceed the cost in which case invest if it’s positive.

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