A Ltd

Investment appraisal

A Ltd is considering the purchase of a new machine. The new machine

manufactures product Z. The price of the machine is R10 000 000 (including
shipping costs of R500 000). A Ltd would have to train its staff to operate the
new machine. The cost of the training is R900 000.

If the new machine is purchased the accounts receivable will increase by R50
000, inventory will increase by R70 000, the cash on hand will increase by
R100 000 and the accounts payable will increase by R25 000.

Product Z is sold for R40 each. The variable manufacturing cost is R21 per
unit. A Ltd would also incur fixed manufacturing costs of R150 000 per year if
the new machine is purchased.

The expected sales volume of product Z is as follows:

Year 1 2 3
Sales volume in units 500 000 550 000 600 000

The new machine has a useful life of 3 years and will be depreciated over its
useful life using the straight-line method. SARS allows a wear and tear
deduction of 50% in the first year of use and 25% in the second and third
year. The wear and tear deduction will be granted on the cost of the
machine as well as on the shipping costs. The cost of the training is not tax
deductible.

A Ltd would borrow money to fund this project. Interest of R750 000 would be
paid annually on the borrowed funds.

The tax rate is 28%. A Ltd’s cost of capital is 17%.

Required:

Calculate the relevant annual cash flows for the new

machine. Calculate the net present value (NPV) for the

new machine.

Should A Ltd purchase the new machine?