Business finance : theory and practice

Chapter 5 • Practical aspects of investment appraisal
Approach B
This involves using an existing machine, which cost £150,000 two years ago, since
when it has been depreciated at the rate of 25 per cent p.a., on cost. The business has
no use for the machine, other than in the manufacture of the new product, so if it is not
used for that purpose it will be sold. It could be sold immediately for £48,000.
Alternatively there is a potential buyer who will pay £60,000 and take delivery of the
machine in one year’s time. There are no additional costs of retaining the machine for
another year.
If the machine is retained for manufacturing the new product, it will be scrapped
(zero proceeds) in two years’ time.
The staff required under Approach B will be transferred from within the business.
The total labour cost involved is £25,000 for each of the next two years. The employees
concerned will need to be replaced for two years at a total cost of £20,000 for each
of those years. The operating profit estimates, given below, are based on the labour
cost of the staff that will actually be working on the new product.
The estimated operating profits, before depreciation, from the new product are as
follows:
Year 1 Year 2 Year 3
£000 £000 £000
Approach A 30 50 60
Approach B 60 40 –
The new production will require additional working capital. This is estimated at 10
per cent of the relevant year’s operating profit, before depreciation. It is required by the
beginning of the relevant year.
The business’s cost of finance to support this investment is 20 per cent p.a.
On the basis of NPV which, if either, of the two approaches should the business adopt?
(Hint: You will need to make the decision about what to do with the old machine if
Approach B is adopted, before you can go on to compare the two approaches.)
5.4* Livelong Ltd has the continuing need for a cutting machine to perform a particular function
vital to the business’s activities. There are two machines on the market, the Alpha
and the Beta. Investigations show that the data relating to costs and life expectancy of
each machine are as follows:
Alpha
Beta
Acquisition cost £50,000 £90,000
Residual value at the end of the machine’s useful life £5,000 £7,000
Annual running cost £10,000 £8,000
Useful life 4 years 7 years
The two machines are identical in terms of capacity and quality of work.
The relevant cost of finance is 10 per cent p.a. Ignore taxation and inflation.
Produce workings that show which machine is the most economical.
By how much, and in which direction, would the acquisition cost of an Alpha need
to alter in order for the two machines to be equally economical?
5.5* Mega Builders plc (Mega), a civil engineering contractor, has been invited to tender for
a major contract. Work on the contract must start in January 20X6 and be completed
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