Milestone Co plans to buy a new machine.

The cost of the machine, payable immediately, is

$800,000 and installation cost is about $20,000. The machine has an expected life of five years.
The firm is using 5-years MACRS depreciation method. At the end of five years, the scrap value
expected to be 5% of the initial cost of machine before tax.

Production and sales from the new machine are expected to be 100,000 units per year. Each unit
can be sold for $16 per unit and will incur variable costs of $11 per unit. Incremental fixed costs
arising from the operation of the machine will be $160,000 per year. The unit selling price is
subject to inflation of 5%, variable cost will inflate 10% each year. Company tax rate is 30% one
year in arrears. Nominal cost of capital is 10%. The inflation will start in the first year. General
inflation rate is 6% per over the years. Target payback is 2 years and company targeted ROCE is
8%.

Note: Compute IRR using interpolation, a = 9%; b = 11%.

Please compute below:

1. Initial investment at year 0!
2. Operating cash inflows over 5 years!
3. Terminal cash flow at the end of year 5!
4. Construct the cash flow timeline!
5. Please advice the company whether this project is financially acceptable (using Payback,
ROCE (using average investment as denominator), NPV and IRR). If these appraisal
techniques produce an inconsistent of decision, then please use your best understanding to
help finance director to make the final ‘accept/reject’ decision!
6. Recalculate the NPV using real cash flows.
7. Calculate the sensitivity of sales revenues, variable costs and initial investment! Which is the
most critical variable that finance director need to put more attention on it?