Southern Star Company is considering replacing an existing piece of machinery with a more sophisticated machine. The existing machine was purchased 3 years ago at a cost of $50,000 and is being depreciated to a zero residual value over 7 years. This machine has 4 years of usable life remaining and can currently be sold for $55,000 net.

The new machine being considered will cost $76,000 and requires an outlay of $4,000 for installation. It will be depreciated over a 4 year period to a zero value and provide the benefit of reducing cash operating costs by $10,000 per annum. (Note: Ignore Tax Implications)

REQUIRED

(a) Given a required rate of return of 14% per annum on capital expenditure proposals, calculate the Net Present Value (Cost). In your own words interpret the meaning of the net present value calculated, nominating whether to continue with the old machine or replace it with the new machine. (Ignore tax implications. / show all working as part of your answer)

Additional information:

The present value of $1,  ie. (1+r)-n      Where: r = discount rate; n = number of periods until payment.

Discount rate (r) 14% Periods (n)

  1 2 3 4

Present value of $1 0.877 0.769 0.675 0.592

(b) In your own words, provide three non-financial factors that should be considered in making the final investment decision, besides the NPV calculation in part (a).

(c) The factory manager at Southern Star says she has heard that the data used in NPV calculations can be unreliable, especially estimates of future cash flows, and that alternative methods of assessing a capital investment would be more reliable. Discuss in your own words the limitations and advantages of NPV analysis over other capital evaluation techniques reviewed throughout the semester.