Reference no: EM132576458
Deve Confectionaries LTD (DCL) is planning to fully automate its current packaging system. The management of the company predicts that, even without any sales change, the company will acquire significant productivity gains which can result huge savings on operation costs with the fully-automation during the next five-year period.
With the proposed plan, the company expect to cease the operation of the old semi-automated packaging plant which still has five years of its' useful life. This plant has been acquired five years ago for $2,500,000. At the end of the useful life, the salvage value of the old plant will be zero. However, if the automation plan implemented now, the remaining of the old plant can be sold for $1,450,000.
The proposed automation is required $4,350,000 to purchase the new machinery and another $250,000 to install the machinery. At the end of the five-year useful life, the salvage value of the new plant would be $2,800,000. The practice of the company is to depreciate the capital assets up to their salvage value during their useful life.
The automation will decrease the current investment in the working capital by $100,000. If company decided to continued with old, working capital would be able to fully recovered the end of the year five. The automation plan also requires to redundant some workers and pay $250,000 as redundancy payment at the end of the year one for those workers. These payments can be deducted for the taxation purpose during the year one.
The estimated annual operational cost before depreciation, interest, and taxes over the 5 years for both the new and the existing system are shown in the following table.
Year 1 2 3 4 5
Proposed new System ($) 250,000 280,000 310,000 320,500 380,000 old system ($) 925,000 930,000 950,000 1,080,000 1,080,000
The business is subject to a 30% tax rate. The company has to incur 9% cost of capital for financing the new system.
You are required to:
(i) Calculate the initial outlay, the incremental operational cash flows (resulted on cost savings), and the terminal cash flow for replacing the existing machine with the new machine.
(ii) Estimate the net present value (NPV), profitability index and payback period of this Investment. Should DCL proceed with the purchase of the new machine?