Haverhill Engineers Ltd manufactures components for the car industry. It is considering automating its line for producing
Question:
Haverhill Engineers Ltd manufactures components for the car industry. It is considering automating its line for producing crankshaft bearings. The automated equipment will cost
£700,000. It will replace equipment with a scrap value of £50,000 and a book written-down value of £180,000.
At present, the line has a capacity of 1.25 million units per year but typically it has been run at only 80 per cent of capacity because of the lack of demand for its output. The new line has a capacity of 1.4 million units per year. Its life is expected to be five years and its scrap value at that time £100,000.
The accountant has prepared the following cost estimates based on the expected output of 1 million units per year:
Fixed overheads include depreciation on the old machine of £40,000 per year and £120,000 for the new machine. It is considered that, for the business overall, fixed overheads are unlikely to change.
The introduction of the new machine will enable inventories to be reduced by £160,000.
The business uses 10 per cent as its cost of capital.
You should ignore taxation.
Required:
(a) Prepare a statement of the incremental cash flows arising from the project.
(b) Calculate the project’s net present value.
(c) Calculate the project’s approximate internal rate of return.
(d) Explain the terms net present value and internal rate of return. State which method you consider to be preferable, giving reasons for your choice.
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