Question

A lathe used for the purpose of cutting molded plastics was acquired 10 years ago for a total expenditure of RM7,500,000. At the time of acquisition, the machine was projected to have a lifespan of 15 years, and the management's initial estimation, which remains unchanged, posited that the residual value would be negligible upon the completion of the aforementioned 15-year period. The machine is subject to depreciation using the straight-line method, resulting in an annual depreciation expense of RM500,000. As a result, the current book value of the equipment stands at RM2,500,000. According to the report provided by the R&D manager, there is a proposition to acquire a new specialized machine at a cost of RM12,000,000, which includes expenses for freight and installation. This machine is projected to have a lifespan of five years and is expected to result in a reduction in both labor and raw material consumption. Consequently, the annual operating costs are anticipated to decrease from RM9,000,000 to RM4,000,000. The decrease in expenses will result in an increase in pre-tax profits of RM9,000,000 - RM4,000,000 = RM5,000,000 annually. According to estimates, the projected salvage value of the new equipment after a period of five years is RM2,000,000. The present market worth of the antiquated machine is RM1,000,000, which is lower than its book value of RM2,500,000. In the event of acquiring the new machine, the decision has been made to sell the old lathe to another company, rather than opting for an exchange with the new machine. The marginal tax rate of the corporation is 40 percent, while the replacement project is characterized by a risk level slightly below the average. The net operating working capital requirements will experience an increase of RM1,000,000 upon replacement. The newly acquired machine is classified under the 3-year Modified Accelerated Cost Recovery System (MACRS) class (33%; 45%; 15%; 7%). Additionally, due to the relatively assured nature of the cash flows associated with the project, the project's cost of capital is determined to be 11 percent, which is lower than the 12 percent typically assigned to projects with average risk.

REQUIRED:
a. Should Iron Corporation proceed with the implementation of the replacement strategy? (Cash flow)
b. Using the Payback Period Method and Discounted Payback Period Method, calculate the
number of years needed to recover the initial cash outlay.
c. Explain the effect of inflation on the cash flows.

Answer 1

Iron Corporation should proceed with the replacement strategy as it is expected to decrease operating costs and increase profits. Using the Payback Period Method, the payback period is calculated to be 2.4 years. The Discounted Payback Period, taking into account the time value of money, is approximately 5.5 years.

Step-by-step explanation:

Based on the given information, Iron Corporation should proceed with the implementation of the replacement strategy. The new specialized machine is projected to result in a reduction in operating costs and an increase in pre-tax profits. With a decrease in expenses of RM5,000,000 annually, the replacement strategy seems financially beneficial for the company.

Using the Payback Period Method, the number of years needed to recover the initial cash outlay can be calculated by dividing the initial cash outlay of RM12,000,000 by the annual cash inflow of RM5,000,000. The Payback Period is 2.4 years.

The Discounted Payback Period Method takes into account the time value of money. To calculate the Discounted Payback Period, the net cash inflows for each year are discounted using the company's cost of capital of 11 percent. By summing the discounted cash flows and dividing the initial cash outlay, the Discounted Payback Period is determined to be approximately 5.5 years.

Inflation can have an impact on cash flows by eroding the purchasing power of money. If the value of money decreases due to inflation, the cost of raw materials, labor, and other expenses may increase. This could affect the profitability of the project by reducing the net cash inflows. It is important for companies to consider the effects of inflation when evaluating the financial viability of a project.