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A worldwide cosmetics company can upgrade the quality of one of its products by purchasing new equipment at a cost of K155,000. The new equipment would replace old equipment that has a current market value of K23,000. The old equipment originally cost K180,000 and was three quarters depreciated. If the old equipment was used for an additional 12 years, its salvage value at that time would be K5,000. The new equipment has an expected life of 12 years. Its salvage value is estimated at K30,000.
By upgrading the quality of this product, the company would be able to increase the sale price. As a result, the operating income before tax will increase by K20,000 per year for the first 3 years, and by K25,000 per year during the last 9 years.
The company’s tax rate is 40% and its cost of capital after tax is 15%. Depreciation is on straight line basis.Required
Compute the net present value (NPV) and the internal rate of return (IRR) for the investment and state whether the company should proceed with the investmentThere is no point in simply typing out a full question and expecting to be provided with a full answer.
You must have an answer in the same book in which you found the question and so ask about whatever it is in the answer that you are not clear about and then I will explain 🙂
Everything needed to be able to answer this question is explained in detail in our free lectures. The lectures are a complete free course and cover everything needed to be able to pass Paper FM well.
How should we calculate the depreciation of the old machine in this question. should we assume that since the machine has 3 quarters depreciated it has also stayed for 3 quarters. meaning are we going to say since the remaining years is a quarter, which is 12 years the other remaining years to balance should be 36 years such that when we add 12+36 we get 48 and use it as total number of years to calculate the depreciation. i don’t understand the “3 quarter depreciated” meaning
This is not exam wording, but it means that it has been depreciated by 3/4 and so its value now is 1/4 of the original cost.
(But, of course, we need the cash flows before depreciation for the calculation of the NPV and IRR.)
Thanks very much John Moffat
so in other words our depreciation of the old machine will be 45000-5000/12=3333.33
my other question would be on salvage. In some books salvage of the old machine is ignored when discounting the terminal cash flow(like in this case only the salvage of the new “30000” would be discounted). While have seen others subtracting salvage of the old from the salvage of the new(meaning in this case they would only discount 25,000 that is 30,000-5,000
so which one is the normal way of dealing with salvage of the old machine when discounting the cash flows?
thanks once more
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