Question 1 [25 marks]

Grapes Limited has to replace a boxing machine that is crucial to its operations. The existing machine does not have the capacity that the company requires. The management of the firm has identified a possible new machine to replace the existing one, which has a book value and scrap value of zero. You have been tasked to evaluate the financial acceptability of the new machine. This will assist management, since they will have objective information regarding which of the machines to investigate further and discuss with possible suppliers.

The bookkeeper of the company provided you with the following information:

The company is taxed at 28%.

The machine will be depreciated on a straight-line basis over the usable life of the project.

The company adjusts its weighted average cost of capital (WACC) of 19%, for the risk inherent in a project by multiplying it by a factor given the coefficient of variation (CV) associated with the sales generated by the project as per the table below:

CV	WACC x (factor to multiply WACC by)
0.1 - 0.25	0.9
0.26 - 0.65	1
0.65 < x	1.2

The project is expected to generate sales of R2 000 000 per year in today's terms.

Inflation is 6%.

Capital gains are taxed at a rate of 22%, on 67% of the gain.

The sales generated by the project have a standard deviation of 500 on expected sales of 2000 per year.

The financial manager of the firm e-mailed you the following:

All our projects are evaluated to take inflation and risk into account. For inflation, we adjust the estimated real cash flows to nominal values. Only sales and variable costs should be adjusted. We use our risk adjusted WACC to evaluate projects.

The cash flows of the new machine have been estimated as follows:

Cash flows	Machine (R000's)
Purchase price	4000
Sales generated per year (in real terms)	2000
Associated variable costs	50% of sales
Fixed costs associated with the machine	500
Increase in net operating working capital	300
Economic lifespan	5 years
Residual value at end of economic life	5000

Required:

Determine the net present value of the machine and comment on the financial acceptability thereof. Also, discuss the risk involved, the effect of capital gains tax and the effect of inflation on the expected acceptability of the machine.