Assignment Task:

Part 1
Capital budgeting and investment decisions    

Simpson Engineering Ltd. manufactures a clothes dryer with a machine that was purchased six years ago for $2,500,000. The clothes dryer is priced at $450 per unit and has variable costs of 43% of the selling price. The existing machine has reached its annual production capacity of 20,000 units and the company is considering replacing it with a new machine. If the existing machine is not replaced, it is expected that it will require repair and maintenance work costing $25,000 every two years from today.

The new machine that the company has identified will cost $4,400,000 with an extra installation cost of $50,000. It will have an annual capacity of 40,000 units. The new machine is also more efficient and variable costs are expected to reduce to 40% of the selling price. Due to the anticipated increase in production, more space is required and this will mean having to repossess an existing floor area that is currently rented to an external tenant for $50,000 per year. It is also estimated that accounts receivable, inventory and accounts payable will increase by $20,000, $45,000 and $25,000 respectively. The effect on cash flows from this change in net working capital is expected to commence at the beginning of the project and will be recovered when the project is terminated. 

A recent seven-year sales forecast conducted by management indicates that sales volume will be 20,000 units next year, 23,000 in year 2, 25,000 in year 3, 30,000 in year 4, 25,000 in year 5, 15,000 in year 6 and 8,000 in year 7. Demand for this product is forecast to drop significantly from the seventh year and the company plans to terminate the production at the end of year 7.

The company has a depreciation policy of straight-line over eight years for this type of machinery. The company estimates that it can sell the existing machine today for $100,000 or for $5,000 if used for another seven years. The new machine can be sold for $200,000 at the end of the project.

The corporate tax rate is 28%. The company’s cost of capital is 11% and it has a policy of requiring a payback period of not more than three years for capital investments.

Required

a) Determine the relevant incremental cash flows for the replacement of the existing machine.                

b) Calculate the payback period, net present value and the internal rate of return of this project.                

Note: You may use the formula function (NPV, IRR) from Excel. However, you have to demonstrate that you know how to calculate NPV and IRR manually by showing your workings. Your manual work will also serve as a double check on the proper use of the Excel functions.
 
Part 2
Lease versus Buy decisions            

As the Finance Director of Simpson Engineering Ltd., you have started work on the financing of the new machine in anticipation that management approves the project. Since there is no available cash for the capital investment, you are considering two options: borrowing to purchase the new machine, or to enter into an operating lease arrangement with a leasing company.

A bank has agreed to provide a loan of $4,450,000 at 6% interest to be repaid in full in seven equal installments at the end of each year. A leasing company has offered to lease a new machine with exactly the same model and specifications to Simpson Engineering Ltd. at $650,000 per year for seven years payable at the beginning of each year plus an option for the purchase of the machine at the end of seven years for $500,000.

The company tax rate and depreciation policy are the same as those in Part 1. The company’s after-tax cost of debt is 5% and is considered to be the appropriate discount rate for the evaluation of the lease or buy option.

Required

a) Calculate the annual payment for the bank loan and prepare a schedule of loan repayments.                

b) Determine the after-tax cash flows and the PV of cash flows for the bank loan option.                        

c) Determine the after-tax cash flows and the PV of the cash flows for the leasing option.                        

Part 3
Recommendations                    

Write a memo (around 200 to 300 words on one page) to the board of directors of Simpson Engineering Ltd. with your recommendations on the following:

a) Whether the project should be accepted and the reasons/rationale supporting your recommendation.                    

b) If the project is to be accepted, which financing option would you recommend and why.                        

c) Apart from financial considerations, discuss the non-financial factors that should be considered in making lease or buy decisions.

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  • Posted on : March 23rd, 2019

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