ACCA FM Syllabus D. Investment Appraisal - Asset Replacement Decision - Past Papers ^{2 / 5}

Ridag Co operates in an industry which has recently been deregulated as the government seeks to increase competition in the industry.

Ridag Co plans to replace an existing machine and must choose between two machines. Machine 1 has an initial cost of $200,000 and will have a scrap value of $25,000 after four years. Machine 2 has an initial cost of $225,000 and will have a scrap value of $50,000 after three years. Annual maintenance costs of the two machines are as follows:

Where relevant, all information relating to this project has already been adjusted to include expected future inflation.

Taxation and tax allowable depreciation must be ignored in relation to Machine 1 and Machine 2.
Ridag Co has a nominal before-tax weighted average cost of capital of 12% and a nominal after-tax weighted average cost of capital of 7%.

What is the equivalent annual cost of Machine 1?

A. $90,412
B. $68,646
C. $83,388
D. $70,609

Ridag Co operates in an industry which has recently been deregulated as the government seeks to increase competition in the industry.

Ridag Co plans to replace an existing machine and must choose between two machines. Machine 1 has an initial cost of $200,000 and will have a scrap value of $25,000 after four years. Machine 2 has an initial cost of $225,000 and will have a scrap value of $50,000 after three years. Annual maintenance costs of the two machines are as follows:

Where relevant, all information relating to this project has already been adjusted to include expected future inflation.

Taxation and tax allowable depreciation must be ignored in relation to Machine 1 and Machine 2.
Ridag Co has a nominal before-tax weighted average cost of capital of 12% and a nominal after-tax weighted average cost of capital of 7%.

Which of the following statements about Ridag Co using the equivalent annual cost method are true?

(1) Ridag Co cannot use the equivalent annual cost method to compare Machine 1 and Machine 2 because they have different useful lives

(2) The machine which has the lowest total present value of costs should be selected by Ridag Co

A. 1 only
B. Both 1 and 2
C. 2 only
D. Neither 1 nor 2

Ridag Co is evaluating two investment projects, as follows.

Project 1

This is an investment in new machinery to produce a recently-developed product. The cost of the machinery, which is payable immediately, is $1·5 million, and the scrap value of the machinery at the end of four years is expected to be $100,000. Capital allowances (tax-allowable depreciation) can be claimed on this investment on a 25% reducing balance basis. Information on future returns from the investment has been forecast to be as follows:

This information must be adjusted to allow for selling price inflation of 4% per year and variable cost inflation of 2·5% per year. Fixed costs, which are wholly attributable to the project, have already been adjusted for inflation. Ridag Co pays profit tax of 30% per year one year in arrears.

Project 2

Ridag Co plans to replace an existing machine and must choose between two machines. Machine 1 has an initial cost of $200,000 and will have a scrap value of $25,000 after four years. Machine 2 has an initial cost of $225,000 and will have a scrap value of $50,000 after three years. Annual maintenance costs of the two machines are as follows:

Where relevant, all information relating to Project 2 has already been adjusted to include expected future inflation. Taxation and capital allowances must be ignored in relation to Machine 1 and Machine 2.

Other information

Ridag Co has a nominal before-tax weighted average cost of capital of 12% and a nominal after-tax weighted average cost of capital of 7%.

Required:

Calculate the equivalent annual costs of Machine 1 and Machine 2, and discuss which machine should be purchased.