Advanced Financial Management: Capital Budgeting (Coursework Sample)

Problem 1.0
The management of Swara Ltd is considering replacing an existing machine which was bought 3yrs ago at a cost of Sh.20million. The machine was expected to have a useful life of 5yrs with no resale value at the end of this period. A critical evaluation of this asset shows that the existing machine is usable for another 5yrs at the end of which resale value is at Sh2million. The current disposal value of the existing machine is estimated at Sh10million.
The new Machine is not available locally. The management expects to import this machine at a cost of Sh40million. Installation cost is estimated to be Sh500,000.
Import duty payable and freight charges are estimated at Sh300,000 and 200,000 respectively. This machine is expected to have a useful life of 5yrs, at the end of which the resale value is estimated at Sh5million.
This investment is expected to lead to an increase in sales. To support the increase in sales, the firm will require extra investment in working capital at the beginning of the new machines’ useful life. Inventory balance is expected to increase by Sh800,000, debtors balance will increase by Sh700,000 and creditors balance will increase by Sh1,000,000.
The firm will require an additional investment in working capital of Sh250,000 at the end of the second year. The total investment in working capital will be recovered at the end of the machine’s useful life.
The earnings before depreciation and tax to be generated by each asset during each year are as follows:
Year New machine Sh ‘000’ Old Machine Sh ‘000’
1 70,000 50,000
2 75,000 55,000
3 85,000 60,000
4 80,000 55,000
5 70,000 65,000
Additional information:
1. The new machine shall require an overhaul costing Sh2million at the end of the third year. The cost will be amortized separately on a straight-line basis.
2. The firm provides for depreciation on all its non-current assets on a straight-line basis.
3. The firm pays corporation tax at the rate of 30%.
4. The firm’s capital structure which is optimal comprises 70% equity and 30% debt. The cost of equity is 10% and the before-tax cost of debt is 8%.
Required:
Using the net present value technique, advise the firm on whether it should replace the existing machine.