The Capital Asset Pricing Model
Capital Budgeting Analysis
You are required to work the following problem, using a discounted cash flow (NPV) analysis. You should model your answer on the text approach in Chapter 8.
“Henry Hall is considering replacing an old machine with a new one. The old machine (purchased 5 years ago) cost $300,000, while the proposed new one will cost $250,000.
“The new machine will be depreciated prime cost to $50,000 over its 5 year life. Henry estimates that it will be worth $40,000 (salvage value) after 5 years.The old machine is being depreciated at prime cost to zero over its original expected life of 10 years. However, Henry can sell the old machine today for $78,000.
“The new machine will save the owner $50,000 a year in cooling costs. This was estimated one year ago in a feasibility study on the new machine conducted for Henry by an external firm of consultants, and which cost Henry $15,000. Henry still considers that these savings will be achieved.
“With the new machine, a one-off amount of cleaning supplies at a cost of $5,000 will be required. and Henry estimates that accounts receivable will increase by $15,000. Both of these increases in working capital will be recouped at the end of the new machine’s life in five years time..
“Henry’s cost of capital is 10%. The tax rate is 30%. Tax is paid in the year in which earnings are received.
“REQUIRED.
(a) Calculate the net present value of the proposed change, that is, the net benefit or net loss in present vaklue terms of the proposed changeover.
(b) Should Henry purchase the new machine? State clearly why.”
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