Evaluate the Acquisition of Manufacturing Equipment
XYZ Limited is a medium sized company providing a range of medical solutions. You, the financial manager has been asked to evaluate the acquisition of new automated manufacturing equipment designed for fast, high quality production runs.
The key financial characteristics of the two proposed machines are summarized below.
This highly automated unit can be purchased for $830,000 and will require $40,000 in installation costs. It will be depreciated at 20% Diminishing Value over 5 years. At the end of 5 years the machine could be sold to net $400,000.
If this machine is acquired, it is anticipated that the following changes to working capital would result.
Cash + $ 25,000
Accounts receivable + $120,000
Inventories - $ 20,000
Accounts payable + $ 35,000
and will be recovered at end of year 5.
This unit is not as sophisticated as Machine A. It costs $640,000 and requires $20,000 in installation costs. It will be depreciated under Diminishing Value at 20% over 5 years. At the end of 5 years, it can be sold to net $330,000. Acquisition of this press will have no effect on the firm's net working capital position.
XYZ estimates that its (cash) earnings for each option,(before depreciation and taxes) would be as follows:
Year Press A Press B
1 250,000 210,000
2 270,000 210,000
3 300,000 210,000
4 330,000 210,000
5 370,000 210,000
The XYZ's tax rate is 33% and from the 'market financial statements' you are provided the following information.
Market Value of Equity: $1.5 million
Market Value of Debt: $0.5 million
The shares are currently selling for $2.10 per share. The required return on equity is 15.87%. The most recent dividend was 27 cents per share. The debt is selling at a discount to its face value and carries a coupon rate of 10% and has a yield to maturity of 12.54%.
(a) Recommend by way of a written presentation to the Board of Directors which, if either, of the machines the company should acquire if XYZ has:
(i) Unlimited funds, and
(ii) Capital rationing - (i.e. a maximum amount to invest of $1.0 million)
Attach schedules of your calculations as an addendum to the report.
NOTE: Treat the cash flows as occurring at the end of each year.
The gain/loss on sale of the presses may have tax implications which are to be treated as occurring at the end of year 5.
(b) What is the impact on your recommendation if the operating cash inflows associated with Machine A are characterized as very risky in contrast to the low risk operating cash inflows of Machine B.