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Your firm is considering whether to replace an existing machine with a new one. The existing machine was purchased five years ago for $200,000 and has an economic life of ten years, that is, it will last for another five years. It will have no salvage value. The operating costs for this machine are $25,000 per year. This machine can be sold today for $80,000. The new replacement machine will do exactly the same job as the existing machine. This machine costs $140,000 and has an economic life of five years and no salvage value. The operating costs for this machine are $17,000 per year. Your firm

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Irving Heathcote
Irving HeathcoteLv2
29 Sep 2019

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QUESTION ONE

Katemba Engineering Limited is a copperbelt province based company. It is considering replacement of an existing machine with a new higher capacity machine. The new machine will cost K672,000. If the new machine is purchased, annual operating cash flows are expected to increase from K210,000 to K378,000. The new machine is planned to have an economic life of five years with end of life scrap value of K147,000. Katemba uses a cost of capital of 11 percent. If the new machine is not purchased, the existing machine is expected to have another five years of useful life with zero end-of-life net scrap value. The current book value of the existing machine is K126,000 but its current scrap value on the secondhand market is K77,000. Assume that the scrap value can be realized immediately and is costless. Ignoring tax considerations;

Calculate the project net cash flow to Katemba Engineering over the next five years if the existing machine is retained. (4 marks)

Calculate the project net cash flow to Katemba Engineering over the next five years if the new machine is purchased. (5 marks)

Using the Net Present Value of capital budgeting, should Katemba engineering purchase the new machine? Justify your answer. (10 marks)

What are some of the challenges that the NPV might present to Katemba Engineering as a method of project evaluation? What alternative method can they employ under these circumstances? (6 marks)

Four years ago a company purchased a new copy machine. Due to deterioration, soon a new copy machine will be needed. The annual maintenance cost for the existing machine is $1,600 and increasing 100 each year. An identical copy machine can be purchased now to replace the presently owned assets. The presently owned copy machine losses each year $10,000 in resale value, compare the assets with at 10% per year and compute when the presently owed should be replace.

Same model as presently owned

Present value (when new) $75,000

Present value of new copy machine $85,000

Annual cost (old copy machine) 1,100

Annual cost (new copy machine) 1,600 and increasing

Salvage value (both machine) 15,000

Life in years (both machine) 6

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