Lynch Castings is planning to replace a continuous casting machine with a newer and more efficient model. The existing model was purchased 5 years ago and cost £20000. It had an expected life of 10 years and salvage value of £4000. However, reliability has become a problem and replacement parts are costing the company £2000 a year. The market for continuous casting machines is currently somewhat flat. The distributors of the best known model currently available are keen to boost turnover and have offered to sell the company a new machine at a large discount to the list price. The price quoted by the distributors is £18000 for cash. The distributors are prepared to buy the old machine from the company for £6000 and claim that the new machine will require no maintenance, will last without problem for five years and they guarantee to buy it back at that time for £2000. The new machine will result in cost savings of £7000 per year but will require additional working capital of £5000 which will be recoverable in five years time. Lynch Castings employs straight line depreciation. The old machine is being depreciated over ten years, the new machine would be depreciated over 5 years. The opportunity cost of capital is 12% and the marginal tax rate is 25%. Depreciation is not allowable as a deduction for tax purposes. a) Explain the internal rate of return (IRR) and net present value (NPV) methods of investment appraisal and discuss why methods which take account of the time value of money are preferable to methods which do not.
Lynch Castings is planning to replace a continuous casting machine with a newer and more efficient model. The existing model was purchased 5 years ago and cost £20000. It had an expected life of 10 years and salvage value of £4000. However, reliability has become a problem and replacement parts are costing the company £2000 a year. The market for continuous casting machines is currently somewhat flat. The distributors of the best known model currently available are keen to boost turnover and have offered to sell the company a new machine at a large discount to the list price. The price quoted by the distributors is £18000 for cash. The distributors are prepared to buy the old machine from the company for £6000 and claim that the new machine will require no maintenance, will last without problem for five years and they guarantee to buy it back at that time for £2000. The new machine will result in cost savings of £7000 per year but will require additional working capital of £5000 which will be recoverable in five years time. Lynch Castings employs straight line depreciation. The old machine is being depreciated over ten years, the new machine would be depreciated over 5 years. The opportunity cost of capital is 12% and the marginal tax rate is 25%. Depreciation is not allowable as a deduction for tax purposes. a) Explain the internal rate of return (IRR) and net present value (NPV) methods of investment appraisal and discuss why methods which take account of the time value of money are preferable to methods which do not.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Lynch Castings is planning to replace a continuous casting machine with a newer and more efficient model. The existing model was purchased 5 years ago and cost £20000. It had an expected life of 10 years and salvage value of £4000. However, reliability has become a problem and replacement parts are costing the company £2000 a year. The market for continuous casting machines is currently somewhat flat. The distributors of the best known model currently available are keen to boost turnover and have offered to sell the company a new machine at a large discount to the list price. The price quoted by the distributors is £18000 for cash. The distributors are prepared to buy the old machine from the company for
£6000 and claim that the new machine will require no maintenance, will last without problem for five years and they guarantee to buy it back at that time for £2000. The new machine will result in cost savings of £7000 per year but will require additional working capital of £5000 which will be recoverable in five years time. Lynch Castings employs straight line depreciation. The old machine is being depreciated over ten years, the new machine would be depreciated over 5 years. The opportunity cost of capital is 12% and the marginal tax rate is 25%. Depreciation is not allowable as a deduction for tax purposes.
a) Explain the internal rate of return (IRR) and net present value (NPV) methods of investment appraisal and discuss why methods which take account of the time value of money are preferable to methods which do not.
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