Muzezi Ltd is a large, all-equity financed, divisionalized textile company whose shares are listed on the London Stock Exchange. It has a current cost of capital of 15 per cent. The annual performance of its four divisions is assessed by their return on investment (ROI), i.e. net profit after tax divided by the closing level of capitalemployed. It is expected that the overall ROI for the company for the year ending 31 December 2018 will be 18 per cent, with the towelling division having the highest ROI of 25 percent. The towelling division has a young, ambitious managing director who is anxious to maintain its ROI for the next two years, by which time he expects to be able to obtain a moreprestigious job either within Muzezi Ltd or elsewhere. He has recently turned down a proposal by his division’s finance director to replace an old machine with a more modern one, on the grounds that the old one has an estimated useful life of four years and should be kept for that period. The finance director has appealed to the main board of directors of Muzezi Ltd to reverse her managing director’s decision.
The following estimates have been prepared by the finance director for the new machine:
Investment cost: $256 000, payable on 2 January 2019.
Expected life: four years to 31 December 2022.
Disposal value: equal to its tax written down value on
1 January 2022 and receivable on 31 December 2022.
Expected cash flow savings: $60 000 in 2019, rising by 10 per cent in each of the next three years. These cash flows can be assumed to occur at the end of the year in which they arise.
Tax position: the company is expected to pay 35 per cent corporation tax over the next four years. The machine is eligible for a 25 per cent per annum writing-down allowance.
Corporation tax can be assumed to be paid 12 months after the accounting year end on 31 December. No provision for deferred tax is considered to be necessary. Old machine to be replaced: this would be sold on 2 January 2019 with an accounting net book value of $50 000 and a tax written-down value of nil. Sale proceeds would be $40 000, which would give rise to a balancing charge. If retained for a further four years, the disposal value would be zero. Relevant accounting policies: the company uses the straight line depreciation method with a full year’s depreciation being charged in both the year of acquisition and the year of disposal. The capital employed figure for the division comprises all assets excluding cash.
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(a) Calculate the net present value to Muzezi Ltd of the proposed replacement of the old machine by the new one. (8 marks)
(b) Calculate, for the years 2019 and 2020 only, the effect of the decision to replace the old machine on the ROI of the towelling division. (7 marks)
(c) Prepare a report for the main board of directors recommending whether the new machine should be purchased. Your report should include a discussion of the effects that performance measurement systems can have on capital investment decisions. (10 marks)
