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Question - John the CEO of A Ltd is thinking of replacing a dicing machine. A Ltd has a beta of 1.15 and 20-year government bonds are yielding 2%. The manufacturing stocks are returning a 4% return on average per year. A Ltd currently has a financial leverage of 30%, with total assets of $250 000. The debt is costing 8% per annum.
The old dicing machine cost $50 000; the new one will cost $30 000. The new machine will be depreciated to zero over 5-year life. It will be worth nothing after 5 years, but taxable dismantling costs of $9 000 will be incurred.
The old dicing machine is being depreciated at a rate of $ 5 000 per year. It will be completely written off in 5 years. If John does not replace it now, he will have to replace it in 5 years. John can sell it now for $12 000. In five years, it will probably be worth nothing.
The new machine will have a taxable savings of $6 000 per year in running cost. The corporate tax rate is 30 percent and tax is paid in the year of income.
Required - Should John purchase the new machine? Justify your answer and show all calculations.
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