Section B

Question B1

Super Tech is considering introducing the second generation of improved tablets, Tab II. If Tab II is introduced it would replace the existing first generation tablets, Tab I, which are currently experiencing declining sales due to improved technology from competitors. Next years sales of Tab I are expected to be 200 million but this is expected to decline at a rate of 10 percent every year.

Over the last two years Super Tech has spent a total of 15 million in research and development costs to develop Tab II. The companys marketing manager thinks that they can sell 2 million Tab II per year globally for 3 years at an average price of 120 each, after which the product will be obsolete. However, this would cost the company 40 million to invest in new machines now to bring Tab II into production. The machines will be depreciated using straight-line basis over a 4-year period, after which, it is expected to realise a salvage value of 8 million (at the end of year 3).

The existing machines to produced Tab I were bought at 25 million four years ago and have been depreciated using straight-line basis over a 5-year economic life. The management does not expect to realise any return from scrapping the old machines in 5 years, but it can be sold today for 5 million.

The new machines are expected to economise on electric power usage, downtime as well as reducing the number of defective tablets. In total, an annual savings of 2 million will be realised if the new machines are bought.

The companys tax rate is 30 percent and the weighted average cost of capital is 20 percent.

Required:

(a) Estimate the annual incremental cash flows from Year 0 to Year 3. (13 marks)

(b) What is the net present value (NPV) of this replacement decision? (3 marks)

(c) What is the internal rate of return (IRR) of this replacement decision? (4 marks)

(d) Based on your calculation in part (b) and (c), what would be your recommendation? (2 marks)

(e) Assume that Super Tech takes a 3-year loan at interest rate of 4 percent per annum in order to invest in the new machines. Explain how this would affect the incremental cash flows estimated in part (a). 4marks

(f) If the weighted average cost of capital increases as a result of taking the loan, how would this affect the NPV in part (b)? 4marks