considering marketing a new product with a four-year life. Epica will need to install new equipment to manufacture the product. Epica has to choose between two machines both of which would be suitable. Machine 1 costs K460,000 to purchase and install, and will have a residual value of K20,000 at the end of four years. Machine 2 costs K630,000 to purchase and install, and has a residual value of K30,000 at the end of four years. Machine 2 takes slightly longer to install and commission, but once in operation it has slightly lower operating costs per unit, and will eventually produce more output. The following projections have been prepared of the cash flows from product sales and operating costs for the two machines: Machine 1 Machine 2
considering marketing a new product with a four-year life. Epica will need to install new equipment to manufacture the product. Epica has to choose between two machines both of which would be suitable.
Machine 1 costs K460,000 to purchase and install, and will have a residual value of K20,000 at the end of four years. Machine 2 costs K630,000 to purchase and install, and has a residual value of K30,000 at the end of four years. Machine 2 takes slightly longer to install and commission, but once in operation it has slightly lower operating costs per unit, and will eventually produce more output.
The following projections have been prepared of the cash flows from product sales and operating costs for the two machines:
Machine 1 Machine 2
Sales K’000 Costs K’000 Sales K’000 Costs K’000
Year 1 1,340 1160 700 610
Year 2 1460 1260 1400 1100
Year 3 1300 1140 1600 1240
Year 4 820 760 900 750
The company’s cost of capital is 12% p.a. All capital investments have to achieve a payback period of three years or less.
Required:
Using the NPV method and paying attention to the condition set on payback, do calculations to show which project should be accepted, and advise the management.
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