Question

Question 1 (25 marks)

You are the Chief Operating Officer (COO) of an electrical appliances

company, Sung-Sam. Currently you are considering replacing the

existing old assembly line with a new one in order to boost the

production capacity and product variety.

The old assembly line was purchased seven years ago at a total cost of

$2.4 million. It has a 12-year economic life with five years remaining

and zero salvage value. If this assembly line was to be sold today, it

would be worth $1 million.

The new assembly line is proposed by Pro-M, a consulting firm with

expertise in manufacturing consultancy. The proposed assembly line

is currently selling at $1.4 million. In addition, Sung-Sam would have

to incur $120,000 shipping and installation expenses and HK$80,000

investment in net working capital. The economic life of the new

assembly line is five years with zero scrap value. It is expected that

the new assembly line can reduce before- tax operating expenses by

$220,000 every year. The company has paid $20,000 to Pro-M to obtain

an evaluation report on the new assembly line.

Sung-Sam uses the straight line depreciation method on all its

production machinery and sets the cost of capital to be 18%. Assume

that the marginal tax rate is 25%.

Answer the following questions:

a

What is a sunk cost in capital budgeting? Do you agree that the

$20,000 to Pro-M is a sunk cost? Why?

(6 marks)

b

What is the initial outlay associated with this proposed purchase?

(6 marks)

16

FIN B280 Introduction to Financial Management

c What are the annual after-tax cash flows associated with this

proposed purchase for years one through to four? What is the after-

tax cash flow in terminal year (year 5)?

(8 marks)

d

Calculate the net present value (NPV) of this replacement decision.

Would you accept the purchase of the new assembly line? Explain

your reason with concept of the goal of the firm.

Answer 1

1. Sunk Cost: The cost already incurred by the company in the past and need not be reflected in the incremental cash flows used for the estimation of net present value and internal rate of return. Sunk cost can’t be recovered.

the $20,000 to Pro-M is a sunk cost because it has been paid to obtain an evaluation report on the new assembly line which was conducted before taking any investment decision and it doesn’t affect any future cash flows.

2. Initial Cash outlay:

	Amount
Cost of Machine	$1400,000
shipping and installation expenses	$120,000
investment in net working capital	$80,000
Initial Cash Outlay	$1600000