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.

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:

 

  1. a)         Estimate the actual cash outlay attributable to the new machine
  2. b)         Determine the incremental cash flows.
  3. c)         Compute the NPV of incremental cash flows.
  4. d)         Add up the present value of the expected salvage value to the P.V. of the incremental cash flow.
  5. 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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