Reference no: EM132985015

Question - Spring Ltd is a small unquoted company which specialises in the production of soft drinks. It purchased a machine 6 years ago at a cost of $90,000. The machine had an expected life of 10 years at the time of purchase, and it is being depreciated by the straight-line method by $9,000 per year. If the machine is not replaced, it can be sold for $10,000 at the end of its useful life.

A new machine can be purchased for $120,000, including installation costs. During its 4-year life, it will reduce direct labor hour by 2,000 hours per year. The hourly rate is $25 for the coming year and will increase by 5% annually. Sales are not expected to change. At the end of its useful life, the machine is estimated to be worthless. Straight-line depreciation method will be used for the new machine.

The old machine can be sold today for $42,000. The firm's tax rate is 20%. The cost of capital is 16%.

Required -

a. If the new machine is purchased, what is the amount of the initial cash flow at Year 0?

b. What are the incremental cash flows that will occur at the end of Years 1 through 4?

c. What is the NPV of the project? Should Spring Lid replace the old machine?

d. Most firms generate cash flows every day, not just once at the end of the year. In capital budgeting, should we recognize this fact by estimating daily project cash flows in the analysis? If we do not, are our results biased? If so, would the NPV be biased up or down? Explain.