ADW Co's Investment in New Machinery: Net Present Value Analysis and Financial Objectives

Calculating the Net Present Value of ADW Co's Planned Purchase

ADW Co is a listed company which plans to meet increased demand for its products by buying new machinery costing £5 million.  The machinery would last for four years, at the end of which it would be replaced. The scrap value of the machinery is expected to be 5% of the initial cost. Capital allowances would be available on the cost of the machinery on a 25% reducing balance basis, with a balancing allowance or charge claimed in the final year of operation. This investment will increase production capacity by 9,000 units per year and all of these units are expected to be sold as they are produced.

Relevant financial information in current price terms is as follows:
Selling price £650 per unit with inflation 4·0% per year
Variable cost £250 per unit with inflation 5·5% per year
Incremental fixed costs £250,000 per year with inflation 5·0% per year

In addition to the initial cost of the new machinery, initial investment in working capital of £500,000 will be required. Investment in working capital will be subject to the general rate of inflation, which is expected to be 4·7% per year.

ADW Co pays tax on profits at the rate of 20% per year, one year in arrears.

The company has a nominal (money terms) after-tax cost of capital of 12% per year.

Question one
(a)Calculate the net present value of the planned purchase of the new machinery using a nominal (money terms) approach and comment on its financial acceptability.
                                                                                                                          
(b)Identify TWO financial objectives of a listed company such as ADW Co and discuss how each of these financial objectives is supported by the planned investment in new machinery.                                                                                                

Case study data

You are working for Ridley Co and are reviewing a four-year project, which the company is considering for investment. The project is in a business activity which is very different from Ridley Co’s current line of business.