Hazel plc produces one of the components used in the manufacture of car bumpers. The production manager is keen on obtaining modern equipment and he has come to you, the finance director, with details concerning two alternative machines, A and B.
The cash flows and other assumptions are as follows.

Machine A would have to be replaced by an identical machine on a two-year cycle.
Machine B would be replaced by an identical machine every three years.
It is considered reasonable to assume that the cash flows for the future replacements of A and B are the same as in the above table.
The opportunity cost of capital for Hazel is 15 per cent.
Ignore taxation.
The acceptance of either project would leave the company's risk unchanged.
The cash flows occur on anniversary dates.
Required
a. Calculate the net present value of Machine A for its two-year life
b. Calculate the net present value of Machine B for its three-year life.
c. Calculate the annual equivalent annuities for Machines A and B and recommend which machine should be selected.
d. You are aware that the production manager gets very enthusiastic about new machinery and this may cloud his judgement. You suggest the third possibility, which is to continue production with Machine C which was purchased five years ago for £400,000. This is expected to produce +£160,000 per year. It has a scrap value now of £87,000 and is expected to last another five years. At the end of its useful life it will have a scrap value of £20,000. Should C be kept for another five years?
e. The production manager asks why you are discounting the cash flows. Briefly explain the time value of money and its components.

Transcribed Image Text:

8000s 000s 5000s Points in time (yearly intervals) Machine A Machine B -200 -240 +220 +220 +242 +242 +266