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Homework answers / question archive / PLC is considering marketing a new product with a four-year life
PLC is considering marketing a new product with a four-year life. Epica will need to install new equipment to manufacture the product. Epica has to choose between two machines both of which would be suitable. Machine 1 costs K460,000 to purchase and install, and will have a residual value of K20,000 at the end of four years. Machine 2 costs K630,000 to purchase and install, and has a residual value of K30,000 at the end of four years. Machine 2 takes slightly longer to install and commission, but once in operation it has slightly lower operating costs per unit, and will eventually produce more output. The following projections have been prepared of the cash flows from product sales and operating costs for the two machines: Year 1 Year 2 Year 3 Year 4 Machine 1 Sales K'000 Costs K'000 1,340 1,160 1,460 1,260 1,300 1,140 820 760 Machine 2 Sales K'000 Costs K'000 700 610 1,400 1,100 1,600 1,240 900 750 The company's cost of capital is 12% p.a. All capital investments have to achieve a payback period of three years or less. Required: Using the NPV method and paying attention to the condition set on payback, do calculations to show which project should be accepted, and advise the management. Total (
| Machine 1 | ||||||
| Year | Sales | Cost | Cash flows | Cumulative cashflows | Discounting factor | Presnt value of cashflows |
| 0 | -460,000 | -460,000 | 1.00 | -460,000 | ||
| 1 | 1,340,000 | 1,160,000 | 180,000 | -280,000 | 0.89 | 160,714 |
| 2 | 1,460,000 | 1,260,000 | 200,000 | -80,000 | 0.80 | 159,439 |
| 3 | 1,300,000 | 1,140,000 | 160,000 | 80,000 | 0.71 | 113,885 |
| 4 | 820,000 | 760,000 | 60,000 | 140,000 | 0.64 | 38,131 |
| 4 | 20,000 | 160,000 | 0.64 | 12,710 | ||
| NPV | 24,879 | |||||
| Machine 2 | ||||||
| Year | Sales | Cost | Cash flows | Cumulative cashflows | Discounting factor | Presnt value of cashflows |
| 0 | -630,000 | -630,000 | 1.00 | -630,000 | ||
| 1 | 700,000 | 610,000 | 90,000 | -540,000 | 0.89 | 80,357 |
| 2 | 1,400,000 | 1,100,000 | 300,000 | -240,000 | 0.80 | 239,158 |
| 3 | 1,600,000 | 1,240,000 | 360,000 | 120,000 | 0.71 | 256,241 |
| 4 | 900,000 | 750,000 | 150,000 | 270,000 | 0.64 | 95,328 |
| 4 | 30,000 | 300,000 | 0.64 | 19,066 | ||
| NPV | 60,149 |
Payback period formula: Year before payback period occurs + (cumulative cashflow in the year of recovery / cashflow in year after recovery)
Machine1:
2 yrs + (80,000/160,000)
= 2yrs + 0.5yrs
= 2.5yrs
Machine 2:
2 yrs + (240,000/360,000)
= 2yrs + 0.67yrs
= 2.67yrs
From the above calculations, it can be concluded that payback for both the machines is less than three years.
Also, from above tables, it can be noted that NPV of machine 2 is more than NPV of machine 1 and hence management should go with machine 2.
