bupe limited purchases a machine 5years ago at a cost of 7.5million. the machine

Question

bupe limited purchases a machine 5years ago at a cost of 7.5million. the machine had an expected life of 15years at the time of purchase and a zero estimated salvage value at the end of 15years. it is being depreciated on a straight line basis and has a book value of 5million at present. the manager reports that for 12million, a new machine can be bought which ove its 10year life will expand sales from 1million to 1.1million a year. further it will reduce labour and raw materails usage sufficiently to cut operating costs from 7million to 5million. the oldmachines current market value is 1milloion. taxes are at 35% and the firms cost of capital is 15percent. should bupe buy the machine?

Explanation / Answer

Bupe Limited All Amounts in $ million Net Present Value of New Machine to be purchased Current Market Value of Old Machine 1 Purchase Cost of New Machine -12 Net Cash Inflows per annum for 10 years Increase in Sales 0.1 Decrease in Operating Costs 2 Income before Taxes 2.1 Tax Impact @ 35% 0.735 Cash Inflows post Taxes 1.365 Cost of Capital 15% Based on the given information, the Net Present Value of the new machine to be purchased works out to -$ 4.50 million Since the Net Present Value worked out as above is negative, Bupe should not buy the new machine.

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