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 at a cost of £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 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 5 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 5 years’ time. Lynch Castings employs straight line depreciation. The old machine is being depreciated over 10 years, the new machine would be depreciated over 5 years. The opportunity cost of capital is 12% and the marginal tax is 25%. 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. Calculate the after tax cash flows for years 0 to 5. Calculate the NPV from replacing the machine. Provide advice on whether the company should go ahead with the purchase of the new machine, setting out any factors which should be taken into account in reaching a decision. Explain how inflation should be taken into account when undertaking investment appraisal. What would the discount rate be for Lynch Castings if all other factors are as above, with the real cost of capital being 12%, but if there is expected inflation of 4% per annum? NOTE: you are NOT REQUIRED to recalculate the cash flow or the NPV taking account of inflation.

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 at a cost of £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 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 5 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 5 years’ time. Lynch Castings employs straight line depreciation. The old machine is being depreciated over 10 years, the new machine would be depreciated over 5 years. The opportunity cost of capital is 12% and the marginal tax is 25%. 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. Calculate the after tax cash flows for years 0 to 5. Calculate the NPV from replacing the machine. Provide advice on whether the company should go ahead with the purchase of the new machine, setting out any factors which should be taken into account in reaching a decision. Explain how inflation should be taken into account when undertaking investment appraisal. What would the discount rate be for Lynch Castings if all other factors are as above, with the real cost of capital being 12%, but if there is expected inflation of 4% per annum? NOTE: you are NOT REQUIRED to recalculate the cash flow or the NPV taking account of inflation.

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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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 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 5 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 5 years’ time.

Lynch Castings employs straight line depreciation. The old machine is being depreciated over 10 years, the new machine would be depreciated over 5 years. The opportunity cost of capital is 12% and the marginal tax is 25%.

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.
Calculate the after tax cash flows for years 0 to 5.
Calculate the NPV from replacing the machine.
Provide advice on whether the company should go ahead with the purchase of the new machine, setting out any factors which should be taken into account in reaching a decision.
Explain how inflation should be taken into account when undertaking investment appraisal. What would the discount rate be for Lynch Castings if all other factors are as above, with the real cost of capital being 12%, but if there is expected inflation of 4% per annum? NOTE: you are NOT REQUIRED to recalculate the cash flow or the NPV taking account of inflation.

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