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.
Should Iron Corporation proceed with the implementation of the replacement strategy?

Answer 1

The decision to proceed with the implementation of the replacement strategy will depend on the financial implications for Iron Corporation. Analysis of the net present value (NPV) and payback period can help determine if the project will create value and recovery of the initial investment in an acceptable timeframe. The cost of acquiring the new machine, salvage value of the old machine, and net operating working capital requirements should all be considered.

Step-by-step explanation:

The decision to proceed with the implementation of the replacement strategy will depend on the financial implications for Iron Corporation. The new specialized machine is projected to decrease annual operating costs by RM5,000,000, resulting in an increase in pre-tax profits. However, the cost of acquiring the new machine is RM12,000,000, which needs to be considered alongside other factors such as the salvage value of the old machine and the net operating working capital requirements.

In order to make a sound decision, Iron Corporation should calculate the net present value (NPV) of the replacement project. By discounting the cash flows associated with the project at the cost of capital of 11 percent, Iron Corporation can determine whether the project will generate a positive NPV. If the NPV is positive, it indicates that the project is expected to create value for the company and therefore, proceeding with the implementation of the replacement strategy would be recommended. Conversely, if the NPV is negative, it suggests that the project would not be financially beneficial and alternative options should be explored.

Furthermore, Iron Corporation should also consider the payback period, which is the length of time it would take to recover the initial investment. If the payback period is within an acceptable timeframe for the company, it could provide additional support for proceeding with the replacement strategy.