- 15 Marks
FM – L2 – Q72 – Discounted cash flow
Question
72 NANTWI PLC
The directors of Nantwi Plc are meeting to decide about the replacement of a machine. The existing machine has to be replaced soon, and there is a choice of two machines that could be purchased to replace it. These are Machine A and a larger Machine, B. The following information is available about each machine:
| Machine A | Machine B | |
|---|---|---|
| Expected working life | 4 years | 5 years |
| Initial cost | GH₵600,000 | GH₵750,000 |
| Residual value | GH₵0 | GH₵0 |
| Working capital requirement | GH₵100,000 | GH₵200,000 |
The forecast pre-tax cash flows that will be earned using each machine are as follows:
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
|---|---|---|---|---|---|
| GH₵000 | GH₵000 | GH₵000 | GH₵000 | GH₵000 | |
| Machine A | 470 | 520 | 490 | 450 | |
| Machine B | 580 | 640 | 500 | 500 | 400 |
Nantwi Plc uses 10% as its cost of capital for capital expenditure evaluation.
Taxation at 30% is payable one year in arrears. Capital allowances are available at the rate of 25% each year on the reducing balance method. Inflation should be ignored.
Required
(a) Calculate the NPV with each of the machines.
(b) Calculate the payback period for each machine.
(c) Recommend with reasons which machine should be purchased.
Answer
72 NANTWI PLC
(a) Tutorial note. There are two ways of calculating the taxation cash flows. One approach is to calculate the tax on the cash profits ignoring capital allowances, and then to calculate the savings in tax payments because of the capital allowances separately. The second approach is to calculate the profit liable to tax in each year and the tax on that profit. Both methods should produce the same net cash flows. The second approach is used here.
Machine A
Workings
| Year 1 | Year 2 | Year 3 | Year 4 | |
|---|---|---|---|---|
| Cost GH₵600,000 | GH₵ | GH₵ | GH₵ | GH₵ |
| Capital allowance (25%) | 150,000 | 112,500 | 84,375 | 253,125 |
| Written down value (WDV) | 450,000 | 337,500 | 253,125 | 0 |
| Operating cash flow | 470,000 | 520,000 | 490,000 | 450,000 |
| Capital allowance | 150,000 | 112,500 | 84,375 | 253,125 |
| Profit liable for tax | 320,000 | 407,500 | 405,625 | 196,875 |
| Tax at 30% on the profit | 96,000 | 122,250 | 121,688 | 59,063 |
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
|---|---|---|---|---|---|---|
| GH₵ | GH₵ | GH₵ | GH₵ | GH₵ | GH₵ | |
| Machine | (600,000) | |||||
| Working capital | (100,000) | 100,000 | ||||
| Operating cash flow | 470,000 | 520,000 | 490,000 | 450,000 | ||
| Tax (one year in arrears) | (96,000) | (122,250) | (121,688) | (59,063) | ||
| Net cash flow | (700,000) | 470,000 | 424,000 | 367,750 | 428,312 | (59,063) |
| Discount factor 10% | 1.000 | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
| Present value | (700,000) | 427,230 | 350,224 | 276,180 | 292,537 | (36,678) |
| NPV = + GH₵609,493 |
Machine B
Workings
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
|---|---|---|---|---|---|
| Cost GH₵750,000 | GH₵ | GH₵ | GH₵ | GH₵ | GH₵ |
| Capital allowance (25%) | 187,500 | 140,625 | 105,469 | 79,102 | 237,304 |
| Written down value (WDV) | 562,500 | 421,875 | 316,406 | 237,304 | 0 |
| Operating cash flow | 580,000 | 640,000 | 500,000 | 500,000 | 400,000 |
| Capital allowance | (187,500) | (140,625) | (105,469) | (79,102) | (237,304) |
| Profit liable to tax | 392,500 | 499,375 | 394,531 | 420,898 | 162,696 |
| Tax at 30% on the profit | 117,750 | 149,813 | 118,359 | 126,269 | 48,809 |
(B) The answer for part (b) is not explicitly provided in the attached document “FM. INVESTMENT APPRAISAL TECHNIQUES. ANS-PART 3.pdf”. The document only includes the answer for part (a) related to NPV calculations for Machine A and Machine B. Since the instruction is to use the answers from the attachment and not generate new ones, I will note that the answer for part (b) is missing from the provided document.
For completeness, the payback period would typically be calculated using the net cash flows provided in the NPV workings for part (a). However, as per the instructions, I will not generate an answer. Instead, I will indicate that the answer is not available in the attachment.
Answer (Missing from Attachment):
The provided document does not include the calculation of the payback period for Machine A and Machine B. Please refer to the original source or provide additional documentation for the complete answer.
(C) The answer for part (c) is not explicitly provided in the attached document “FM. INVESTMENT APPRAISAL TECHNIQUES. ANS-PART 3.pdf”. The document only includes the answer for part (a) related to NPV calculations for Machine A and Machine B. Since the instruction is to use the answers from the attachment and not generate new ones, I will note that the answer for part (c) is missing from the provided document.
For completeness, the recommendation would typically be based on the NPV results from part (a) and other qualitative factors. However, as per the instructions, I will not generate an answer. Instead, I will indicate that the answer is not available in the attachment.
Answer (Missing from Attachment):
The provided document does not include the recommendation for which machine to purchase or the reasons for the choice. Please refer to the original source or provide additional documentation for the complete answer.
- Tags: Capital Budgeting, Investment decision, Machine Replacement, NPV
- Level: Level 2
- Topic: Capital budgeting
- Uploader: Samuel Duah