Question

The salesman from Superfast Machines claims that if you trade-in your old machine for one of his new machines, you could save your company $60,000 a year. As his new machine costs $120,000 after the trade-in, the investment pays for itself in 2 years. Since the machine has a life of 3 years and a salvage value of $30,000, the salesman claims that this deal lets you use the machine for free in year 3 as well as receiving a $30,000 when the machine is sold. Having learnt about capital budgeting techniques, you are quite skeptical of his claims. Use the data below to do your own sums.

• Cost of new machine $120,000
• Salvage value of machine at end of life $30,000
• Useful life 3 years
• Operating cost savings $60,000
(excluding depreciation) from new machine
• Depreciation policy Depreciate to zero
You have also obtained the following financial information regarding the company and the market.

Shares
• Issued 2,000,000 shares.
• Current share price = $10
• Company just paid a dividend of $1.20 per share. Dividends are expected to be maintained at this level for the foreseeable future.
• Beta of shares = 1.0

Bonds
• Issued 20,000, 5% coupon bonds with par value of $1,000 with remaining maturity of 10 years.
• Bonds are currently selling at the par value.

Market
• 10-year Treasury bond yield = 4%
• 10-year AAA bond yield = 4.5%
• 10-year AA bond yield = 5%
• Expected return of the stock market = 12%
• Corporate tax rate = 20%

(a) Compute the cost of equity, cost of debt and the weighted average cost of capital.

(b) Explain which capital budgeting method the salesman is using when he claims that the machine pays for itself in 2 years.

(c) Calculate the operating cash flows related to this project.

(d) Calculate the cash flows from assets for the project.

(e) Determine whether the machine should be bought.

(f) Discuss two (2) advantages of using the NPV versus the payback period.