Examiners' commentaries 2011

92 Corporate finance
6
Section B
Answer one question from this section and not more than a further
two questions. (You are reminded that four questions in total are to be
attempted with at least one from Section A.)
Question 5
a. Leopard plc is considering purchasing a new machine in its manufacturing
plant. The machine is required on a going concern basis. The company has the
following two options:
Machines Year 0 Year 1 Year 2 Year 3 Year 4
A –100,000 90,000 80,000 50,000
B –150,000 35,000 45,000 55,000 65,000
All figures are quoted in $. The cost of capital for Leopard plc is 10% per
annum. In which machine should Leopard plc invest?
Reading for the question
BMA, Chapter 6, pp.169–73.
Approaching the question
(6 marks)
Machine A
Year CF’s DF PV AEV
0 –100 1 –100
1 90 0.909 81.81
2 80 0.826 66.08
3 50 0.751 37.55
2.486 85.44 34.368
Machine B
Year CF’s DF PV AEV
0 –150 1 –150
1 35 0.909 31.815
2 45 0.826 37.17
3 55 0.751 41.305
4 65 0.683 44.395
3.169 4.685 1.478
Given that Machine A has the higher NPV and AEV (annual equivalent
value), we should invest in it.
b. GQ Ltd has been presented with the following project:
A new machine for $250,000 is required at the beginning of the first year. The
machine will last for 4 years and thereafter can be disposed of for $25,000.
The company’s policy is to depreciate this type of machine over its economic
life on a straight-line basis.
The demand for the product MH depends on the future states of the
economy. In the good state, GQ Ltd expects to sell 15,000 units per year for
the next 4 years. If the economy is bad, sales will fall to 5,000 units per year.
Each state of the economy has an equal probability to materialise. Each unit
of product MH will be priced at $40. Total variable costs are expected to be
$30 per unit in the first year and thereafter rise at 10% per year.
[For the full question, please refer to the Examination paper.]