Reference no: EM132804368

Viti Timbers Ltd is manufacturing business listed on South Pacific Stock Exchange (SPX). The manager is considering the purchase of a new, fully automated assembly machine to replace an older, manually operated one. The machine being replaced, now five years old, originally had an expected life of ten years, and it was being depreciated using the straight-line method from a cost of $20000 down to zero, and could be sold for $15000. The old machine was operated by one operator who earned $15000 per year in salary and $2000 per year in fringe benefits. The annual costs of maintenance and defects associated with the old machine were $7000 and $3000 respectively. The replacement machine being considered has a purchase price of $50000, a salvage value after five years of $10000 and would be fully depreciated over five years using straight-line method of depreciation. The automated machine will not require any operator. To get the automated machine in running order, there would be a $3000 shipping fee and a $2000 installation charge. In addition, because the new machine would work faster than the old one, investment in raw materials and goods-in-process inventories would need to be increased by a total of $5000. The annual costs of maintenance and defects on the new machine would be $2000 and $4000 respectively. The new machine also requires maintenance workers to be specially trained; fortunately, a similar machine was purchased three months ago, and at that time the maintenance workers went through the $5000 training program needed to familiarise with the new equipment. Finally, to finance the purchase of new machine, the firm would have to borrow a $20000 at 9% interest from its local bank, resulting in interest payments of $1800 per year. The required rate of return for this kind of projects is 20%.

REQUIRED

Problem 1. Identify the relevant cash flows and calculate the project's net present value (NPV). Should the company go ahead with machine replacement?

Problem 2. Calculate the payback period.

Problem 3. One of the real world complexities that managers come across in long-term investment planning is assessing new projects based on capital rationing. Discuss some reasons for capital rationing and explain how financial managers would make decisions if investment projects are subject to capital rationing.