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Question 1 Plasma Ltd, makers of plasma televisions, is considering also making DVD players. They have...

Question 1 Plasma Ltd, makers of plasma televisions, is considering also making DVD players. They have the choice of two machines with which to make the DVD players, and both could do the job adequately. They have called upon you to assist them in deciding whether Machine A or Machine B should be purchased. Both machines are to be depreciated straight line down to a book value of zero over their entire useful life. Despite this, it is anticipated that Machine A will be sold for $8,000 and Machine B for $12,000 at the end of their useful lives. Details of each project’s cash flows are tabulated below: Machine A Machine B Cost $450,000 $624,000 Pre-Tax Net Annual Inflow (these cash flows occur at the end of the year) $160,000 $210,000 Machine Life 10 years 12 years In addition to the cash flow information, you have also been provided with the following details: • The corporate tax rate is 30%; • Tax is payable annually in arrears (ie tax is paid on profits one year after it is earned); • The project is in an industry which is 15% less risky than the industry in which the firm currently operates; • Plasma Ltd currently has a beta of 1.7; • The market risk premium is 10% p.a.; and, • The expected return on the market is 18% p.a. Given this information, which machine, if any, do you recommend Plasma Ltd purchase? In providing your answer, explain why you have made your recommendation.

Homework Answers

Answer #1

Beta of the project = 1.7*(1-15%) = 1.445

Required retrun = Rf + Beta*(Rm-Rf)

=8%+1.445*10%

=22.5%

as machine B is having higher net present value, Machine B should be choosed calculation is given below:-

Formulas USed:-

Particular Machine A Machine B
Initial Cost 450000 624000
Salvage value 8000 12000
Depriciation =B4/10 =C4/12
Pre-tax CashFlow 160000 210000
cashflow after Tax =(B7-B6)*(1-$B$2)+B6 =(C7-C6)*(1-$B$2)+C6
NPV =PV($B$1,10,-B8,-B5)-B4 =PV($B$1,12,-C8,-C5)-C4

I hope my efforts will be fruitful to you.

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