Question

Question four (b) Machines Alpha and Beta have the following cash flows: Cash flows (Shs '000") Co C3 CA C co Alpha -480 440 480 520 560 600 640 Beta -480 440 484 532 Machine Omega was purchased five years ago for Shs 800,000 and produces an annual cash flow of Shs 320,000. It has no salvage value but is expected to last another five years. The company can either replace Omega with Alpha now or replace it with Beta at the end of five years. The company's cost of capital is 10% per annum. What should the company do? Show appropriate computations. (9 marks)

Answer 1

Let's assume the working for this question is for 7 years
as the Alpha has maximum years of cash generation
Option 1:	Replace Omega with Alpha now
Year	Cash from Alpha	PV factor	PV of Cash Flow
0	-4,80,000	1.00	-4,80,000
1	4,40,000	0.91	4,00,000
2	4,80,000	0.83	3,96,694
3	5,20,000	0.75	3,90,684
4	5,60,000	0.68	3,82,488
5	6,00,000	0.62	3,72,553
6	6,40,000	0.56	3,61,263
		NPV	18,23,682
Option 2: Replace Omega at the end of 5th year with Beta
Year	Cash Flow from Omega	Cash Flow from Beta	Net Cash Flow	PV factor	PV of Cash Flow
1	3,20,000	-	3,20,000	1.00	3,20,000
2	3,20,000	-	3,20,000	0.91	2,90,909
3	3,20,000	-	3,20,000	0.83	2,64,463
4	3,20,000	-	3,20,000	0.75	2,40,421
5	3,20,000	-4,80,000	-1,60,000	0.68	-1,09,282
6	-	4,40,000	4,40,000	0.62	2,73,205
7	-	4,84,000	4,84,000	0.56	2,73,205
				NPV	15,52,921
The option to buy Alpha is clear as having higher NPV.