FIN722 Assignment No 1 Fall 2014 Solution and Discussion December 2014

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CASE:
Valencia Leather Inc. is considering the replacement of one of its important machineries with a new
one. It has received two proposals and evaluated the performance characteristics of the proposals
closely, which are as follows:
Proposal I:
Nawab Machinery costs Rs. 740,000 and it has a useful life of 8 years assuming that it will require an
overhaul in the fifth year. Maintenance costs of Rs. 20,000 a year are expected in the first four years,
followed by an overhaul cost of Rs. 130,000 in the fifth year. During the last three years,
maintenance costs are expected to be Rs. 40,000 a year. At the end of eight years, the machinery will
have an estimated scrap value of Rs. 90,000.
The cash inflows attached with the machinery for 8 years are as follows:
Year 1 2 3 4 5 6 7 8
CF (Rs.) 150,000 160,000 140,000 150,000 130,000 210,000 230,000 180,000
Proposal II:
Malik Machinery is for Rs. 590,000, inexpensive than the Nawab’s. Its maintenance costs are
expected to be Rs. 30,000 and this amount is expected to increase by Rs. 15,000 a year through the
eighth year. In the fourth year, an overhaul of the machinery will be required, which will cost the
company Rs. 150,000 in addition to maintenance costs in that very year. At the end of eight years the
machinery will have an estimated scrap value of Rs. 90,000.
The cash inflows attached with the machinery for 8 years are as follows:
Year 1 2 3 4 5 6 7 8
CF (Rs.) 170,000 180,000 160,000 230,000 160,000 210,000 220,000 190,000
By looking at the monetary figures attached with the proposals, Mr. Anwar (CEO, Valencia Leather
Inc.) is convinced that second proposal is worth undertaking as it is not only inexpensive but also
generating higher cash inflows.
Required:
a. Being a student of Corporate Finance, you are required to evaluate both proposals by
calculating their NPVs and IRRs. The company’s opportunity cost of funds is 8 percent.
(IRR should be calculated by using the interpolation formula/technique as
shown in the additional material uploaded in the lesson contents of Lesson # 10)
b. Is Mr. Anwar rightly convinced? Support your answer with analytical reasoning.