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The management of Biashara Ltd is evaluating two machine models, Alpha and Beta, to increase production. Alpha costs $3,800,000 with a 4-year life while Beta costs $8,000,000 with a 6-year life. Both machines have no salvage value and require $825,000 in initial working capital. Alpha is estimated to generate $1,800,000 per year while Beta is estimated to generate $2,400,000 per year. Based on a 12% cost of capital and 30% tax rate, the NPV of Alpha is $1,432,880 while Beta's NPV is $3,644,400, so Beta is the recommended purchase. Even if Alpha

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66 views1 page

42382

The management of Biashara Ltd is evaluating two machine models, Alpha and Beta, to increase production. Alpha costs $3,800,000 with a 4-year life while Beta costs $8,000,000 with a 6-year life. Both machines have no salvage value and require $825,000 in initial working capital. Alpha is estimated to generate $1,800,000 per year while Beta is estimated to generate $2,400,000 per year. Based on a 12% cost of capital and 30% tax rate, the NPV of Alpha is $1,432,880 while Beta's NPV is $3,644,400, so Beta is the recommended purchase. Even if Alpha

Uploaded by

mahmoudfatahabukar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Question

• The management of Biashara Ltd. is in the process of evaluating two


alternative machine models, Alpha and Beta for possible purchase in order to
increase the company's production level.
The following additional information is available:
1. Alpha costs Shs. 3,800,000 and will have a useful life of four years.
2. Beta costs Shs. 8,000,000 and will have a useful life of six years.
3. Both machines have no salvage value after their useful lives.
4. An investment in working capital amounting to Shs. 825,000 will have to be made
at the beginning of the first year of the machines life regardless of the
model purchased.
5. The estimated pre-tax cash inflows for each of the machines are shown below:

6. The cost of capital to the company is 12% and the corporation tax rate is 30%.
Required:
(i) Calculate the undiscounted pay back period for each machine model.
(ii) Calculate the net present value (NPV) for each machine model.
(iii) Using the net present values computed in
(ii) above, advise the management on
which model to purchase.
(iv) The management of the company has received an alternative offer to lease
Alpha at an annual lease charge of Shs. 1,200,000 for four years, payable at
the year end. All other details remain unchanged.
Will this offer affect your selection in part
(iii) above? Explain.

Answer

Total P.V of Alpha = I0 + NPV = 4,625 + 1,432.88 = 6,057,880


New NPV with lease = 6,057,880 – 3,644,400 = 2,413,480 Therefore Beta is still preferable.

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