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Finance Assignment Question

The company have decided to install a new machine.The machine costs $2000 and it is estimated that it will have a useful life of five years with a trade value or $4000 at the end of the fifth year. Management have estimated that the new machine would yield additional cash profit of $8000 per year for the next 5 years. The management are considering two different ways of financing the new machine.

Option One

Purchase the machine for cash, by borrowing money from the bank. The interest cost would be 14% before tax.

Option Two

Lease the machine under an agreement which would require the firm to make a $4800 payment to the leasing company at the end of each year for the next 5 years.

The company’s weighted average cost of capital (WACC ) is 13% after tax and the company pays tax at 35 %.If the company decide to purchase the machine they will be able to claim a writing down allowance of 25% of the reducing balance per anumn.This would mean that the first write down allowance would be claimed in a year one resulting in a tax saving for year two.

Required:

  • Prepare a a financial statement to show whether or not the firm should acquire the machine
  • Prepare a financial statement showing how the firm should finance the new machine
  • Why is the use of an asset more important to a firm than its ownership and outline after factors which should be considered by the firm’s management before making a decision to acquire the machine?

Finance Assignment Solution

NPV

The cost of the machine is €20000 and is expected to increase the cash flows as seen in the above table.

Here, we can see that the additional cash flows due to the installation of a new machine is €8000.Now, we know that the after tax weighted average cost of capital=13%

Hence, we would now compute the NPV and IRR for this project to know whether the firm should acquire the machine and if it adds to the firm value.

NPV = -20000 +8000/(1+r) + 8000/(1+r)^2 + 8000/(1+r)^3 + 8000/(1+r)^4 + 8000/(1+r)^5 (Ross, 2013)

=28137.85

IRR

We would now be calculating the Internal Rate of Return for the Project. The internal rate of return for the project is calculated when the NPV is zero. (Ross, 2013)

After calculating in excel on the basis of the cash flows obtained above,

IRR=29%

Here, we observe that the IRR is greater than WACC and hence the firm should acquire the machine in order to boost the cash flows. The cost of capital is the average required rate of return with respect to the risk associated to the firm.

Since the required rate of return is more than the cost of capital, it would be a wise decision for the firm to install a new machine and also a good opportunity to increase shareholder wealth. 

Question 2

The firm has now decided to buy the machine. It is in the process of deciding which type of financing should be used. We currently have two options. The first one is debt financing and the other one is lease financing.

In the case pertinent to Estrella we are currently reviewing two options. The company has decided to install a new machine. The management believes that the installation of the new machine would bring additional cash flows.

We will now review the two options by calculating the cash flows. One of the options is to buy the new machine and the other option is to lease the machine.

Option 1(Purchasing the Machine)

The cost of the new machine is €20000. When the machine is purchased from the bank, the interest rate is 14%.The useful life of the machine is 5 years and the trade in value at the end of the fifth year is €4000.

In the below calculation we will observe the capital allowance that is taken into consideration. When the machine is purchased, a writing down allowing of 25% of the reducing balance per annum is claimed. The following calculation is pertinent to the writing down allowance.

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