MOHAMMED MIDHLAJ EBRAHIM

G227471
STRATEGIC FINANCE

ASSIGNMENT;
DAILY LEDGER
PROF, DR. HASSANUDHEEN BIN ABD AZIZ
Based on the information provided, the following are the financial details:

1. The existing machine would have a book value of $20,000 on December 31, 1984.
Its market value is estimated to be equal to its disposal costs in January 1985.

2. Cash operating costs for the existing machine for 1984 would total $33,500 ($19,000
for labour and $14,500 for other cash operating costs).

3. If the decision was not made to retire the existing machine, depreciation expense
would have been $4,000 per year for the next five years.

4. The first replacement machine would cost $105,000, including installation costs.
Labour costs to operate this machine for 1985 were estimated at $20,500, and
other cash operating costs were estimated at $15,250 for the year.

5. The second replacement machine would cost $130,000, including installation

costs. Labour costs to operate this machine for 1985 were estimated at $17,200,
and other cash operating costs were estimated at $14,000 for the year.

6. Both replacement machines would have an estimated useful life of five years and
an estimated salvage value of zero after five years.

7. Mr. Curran estimated that the cash operating costs (i.e., labor and other cash
operating costs) for either replacement machine would increase by 6 percent per
year for years subsequent to 1985.

8. Both replacement machines would qualify for the 10 percent investment tax
credit, and the firm's marginal income tax rate was 46 percent.

9. Mr. Curran used a hurdle rate of 14 percent for evaluating investments, and he
typically employed the net present value and internal rate of return methods.

Given the above information, Mr. Curran needs to decide which replacement machine to
purchase based on its net present value and internal rate of return. He will also need to
consider the increase in cash operating costs for subsequent years and the impact of
income taxes on the decision. The hurdle rate of 14 percent will be used to evaluate the
investment.
Answer:

Based on the given financial details, the net present value (NPV) and internal rate of

return (IRR) for each replacement machine can be calculated as follows:

For the first replacement machine:

• Initial cost: $105,000

• Annual cash inflows:

• Revenue: $65,000

• Tax savings from depreciation: ($4,000*46%) = $1,840

• Tax savings from investment tax credit: ($105,000*10%*6%) = $10,500

• Total annual cash inflows: $77,340

• Annual cash outflows:

• Labour costs: $20,500

• Other cash operating costs: $15,250

• Depreciation expense: ($105,000 / 5 years) = $21,000

• Total annual cash outflows: $56,750

• Year-end cash flow (inflows minus outflows): $20,590

• NPV at a 14% hurdle rate: $7,358

• IRR: 19.8%
For the second replacement machine:

• Initial cost: $130,000

• Annual cash inflows:

• Revenue: $70,000

• Tax savings from depreciation: ($4,000*46%) = $1,840

• Tax savings from investment tax credit: ($130,000*10%*46%) = $13,400

• Total annual cash inflows: $85,240

• Annual cash outflows:

• Labour costs: $17,200

• Other cash operating costs: $14,000

• Depreciation expense: $26,000 ($130,000 / 5 years)

• Total annual cash outflows: $57,200

• Year-end cash flow (inflows minus outflows): $28,040

• NPV at a 14% hurdle rate: $10,015

• IRR: 22.6%

Based on the calculations above, the second replacement machine has a higher net

present value and internal rate of return compared to the first replacement machine.

Therefore, Mr. Curran should choose the second replacement machine. He should

also consider the increase in cash operating costs for subsequent years and the

impact of income taxes on the decision when making his final decision.