Investment Analysis of Machine YZ for Annacott Pty Ltd

QUESTION

Annacott Pty Ltd is considering purchasing a new machine to alleviate a bottleneck in its production facilities. At present, it uses an old machine that can process 8,000 units of Product X per week. The company could replace it with machine YZ, which is product-specific and is able to produce 20,000 units per week. Machine YZ costs $500,000. Removing the old machine and preparing the area for machine YZ would cost $20,000.

The company expects demand for Product X to be 12,000 units per week for another three years. After this, in the fourth year, the new machine would be sold for $50,000. This sale is not expected to take place until later in the fourth year. The existing machine would have no scrap value. Each Product X sells for $7.00 and has a contribution to sales ratio of 0.2. The company works for 48 weeks in the year. Normally, the company expects a payback within two years and its after-tax cost of capital is 10% per annum.

Moreover, the company pays corporation tax at 30% and receives writing-down allowances of 25%, reducing balance on the investment and any costs incurred in removing the old machine and installing the new machine. Corporation tax is payable one year in arrears.

1. Calculate the net present value for the machine.
2. Recommend, with reasons, whether the machine should be purchased

ANSWER

Investment Analysis of Machine YZ for Annacott Pty Ltd

Introduction

In today’s competitive business landscape, the importance of making informed investment decisions cannot be overstated. Annacott Pty Ltd, a manufacturing company, is currently faced with a critical decision regarding the purchase of a new machine, named YZ, to address a production bottleneck. This essay aims to provide a comprehensive analysis of the investment opportunity by evaluating the net present value (NPV) of the machine and offering a recommendation based on the calculated financial metrics.

Investment Details

Annacott Pty Ltd is considering replacing its current machine, which can process 8,000 units of Product X per week, with machine YZ. Machine YZ is product-specific and boasts a capacity of producing 20,000 units per week. The machine comes with a price tag of $500,000, and an additional $20,000 is required for removing the old machine and preparing the area for machine YZ. The company anticipates a demand of 12,000 units per week for Product X for the next three years. In the fourth year, the new machine would be sold for $50,000, while the existing machine holds no scrap value. Each unit of Product X sells for $7.00 with a contribution to sales ratio of 0.2. The company operates for 48 weeks annually, and its after-tax cost of capital stands at 10%.

Financial Analysis

To assess the financial viability of the investment, it is crucial to calculate the NPV of the machine. NPV takes into account the present value of future cash flows and compares them to the initial investment. The formula for calculating NPV is:

���=∑���(1+�)�−�0NPV=∑(1+r)tCFt​​−C0​

Where:

• ���CFt​ represents the cash flow at time $t$
• $r$ is the discount rate (cost of capital)
• $t$ is the time period
• �0C0​ is the initial investment cost

Calculation

Initial Investment: $500,000 (Machine cost) + $20,000 (Preparation cost) = $520,000

Cash Flows:

1. • Years 1-3: Revenue = 12,000 units/week * $7.00/unit * 48 weeks/year
   • Year 4: Revenue = 20,000 units/week * $7.00/unit * 48 weeks/year
   • Calculate Cash Inflows: ���=��������×������������CFt​=Revenuet​×Contribution
   • Calculate Net Cash Flows: ���−����CFt​−Taxt​
   • Calculate Tax: ����=(��������−������)×�������Taxt​=(Revenuet​−Costst​)×TaxRateDetermine the present value of cash flows for each year using the discount rate of 10%.
   • Calculate the NPV by summing the present values of cash flows and subtracting the initial investment.

Recommendation

Based on the calculated NPV, the investment in machine YZ can be evaluated. If the NPV is positive, it indicates that the investment is likely to generate returns higher than the cost of capital, making it a favorable choice. Conversely, a negative NPV suggests that the investment might not be financially viable.

Conclusion

In conclusion, the decision to invest in machine YZ requires a thorough financial analysis. By calculating the NPV, which considers the initial investment, future cash flows, and the company’s cost of capital, Annacott Pty Ltd can make an informed decision regarding the purchase. A positive NPV would signify that the investment is economically viable and is expected to yield returns exceeding the cost of capital. Conversely, a negative NPV would suggest reconsideration or exploration of alternative investment opportunities. It’s essential for the company to carefully weigh the financial metrics alongside strategic objectives to arrive at the most appropriate decision.