Katemba Engineering Limited is a copperbelt province based company. It is considering replacement of an existing machine with a new higher capacity machine. The new machine will cost K672,000. If the new machine is purchased, annual operating cash flows are expected to increase from K210,000 to K378,000. The new machine is planned to have an economic life of five years with end of life scrap value of K147,000. Katemba uses a cost of capital of 11 percent. If the new machine is not purchased, the existing machine is expected to have another five years of useful life with zero end-of-life net scrap value. The current book value of the existing machine is K126,000 but its current scrap value on the secondhand market is K77,000. Assume that the scrap value can be realized immediately and is costless. Ignoring tax considerations; (a) Calculate the project net cash flow to Katemba Engineering over the next five years if the existing machine is retained. (b) Calculate the project net cash flow to Katemba Engineering over the next five years if the new machine is purchased. (c) Using the Net Present Value of capital budgeting, should Katemba engineering purchase the new machine? Justify your answer. (d) What are some of the challenges that the NPV might present to Katemba Engineering as a method of project evaluation? What alternative method can they employ under these circumstances?
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
Katemba Engineering Limited is a copperbelt province based company. It is considering replacement of an existing machine with a new higher capacity machine. The new machine will cost K672,000. If the new machine is purchased, annual operating cash flows are expected to increase from K210,000 to K378,000. The new machine is planned to have an economic life of five years with end of life scrap value of K147,000. Katemba uses a cost of capital of 11 percent. If the new machine is not purchased, the existing machine is expected to have another five years of useful life with zero end-of-life net scrap value. The current book value of the existing machine is K126,000 but its current scrap value on the secondhand market is K77,000. Assume that the scrap value can be realized immediately and is costless. Ignoring tax considerations;
(a) Calculate the project net cash flow to Katemba Engineering over the next five years if the existing machine is retained.
(b) Calculate the project net cash flow to Katemba Engineering over the next five years if the new machine is purchased.
(c) Using the
(d) What are some of the challenges that the NPV might present to Katemba Engineering as a method of project evaluation? What alternative method can they employ under these circumstances?
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