Beeline Ltd must decide whether to keep an ageing machine or replace it with Machine A or Machine B. Every figure in the question is real, but not every figure is a relevant cash flow. Sort each item into include or exclude and watch what each choice does to the NPV of all three options. The margins are narrow: one wrong call can change the decision.
The question
Beeline Ltd (Question 8.24)
Existing machine
Bought 5 years ago for
R1 940 000
Original useful life
10 years
Can be sold today for
R760 000
Major service due if kept
R480 000
Net cash flow before tax
R720 000 p.a.
Remaining life · residual
5 years · nil
Working capital tied up
R400 000
Machine A
Cost
R2 800 000
Effective life (SARS)
5 years
Working capital
R200 000
Residual value, year 5
R560 000
Annual cash flow before tax
R1 100 000
Machine B
Cost
R4 750 000
Effective life (SARS)
5 years
Working capital
R100 000
Residual value, year 5
R950 000
Annual cash flow before tax
R1 550 000
The firm
Tax rate
28%
Cost of capital
10%
Tax allowance
Straight-line, 5 yrs
The textbook uses 28%. The current South African company rate is 27%.
The sorting board
Include it or exclude it?
† Items marked with a dagger are not in Q8.24. They are typical traps added for practice.
The schedule
The cash flows you have built
Item
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Present value
Rows in red are items you have included that should be excluded. Items you have wrongly excluded simply disappear from the table, which is exactly how the mistake hides in an exam answer.
The size trap
Why you cannot rank these options by their own IRR
Using the correct cash flows, look at each option's IRR on its own. Keeping the old machine needs only the after-tax service cost up front, so its IRR is enormous. It still creates the least value. A percentage ignores how many rands are invested; the NPV does not.
Option
Outlay at year 0
Own IRR
Rank by IRR
NPV at 10%
Rank by NPV
Assumptions
Where the question leaves room for judgement
The question does not settle these points. The defaults below are the most common textbook reading. Change them to match your own model answer; the "correct" NPVs recalculate.
Tax life of the existing machine
With 10 years, half the cost is still unclaimed. Selling below that value gives a scrapping allowance, and keeping the machine keeps R194 000 of allowances a year. With 5 years, the tax value is nil and any sale price is recouped.
Is the major service tax-deductible?
A service that restores the machine is normally a deductible repair (s11(d)), so it costs R345 600 after tax. Treating it as capital removes the immediate tax saving. Either way it belongs only to the "keep" option.
Timing conventions used
Tax effects of year-0 items (service, scrapping allowance) are shown at year 0. Annual cash flows arrive at year-end. The existing R400 000 of working capital is released at year 0 if the machine is sold, and at year 5 if it is kept.
The rules this question tests
Incremental cash flows only. Ask what changes because of the decision, not what the business earns in total.
Sunk costs are out. The R1 940 000 was spent five years ago under every option. It matters only for working out the tax value.
Opportunity costs are in. Keeping the machine gives up R760 000 of cash today, plus the release of R400 000 of working capital.
Depreciation is not a cash flow. The cost is already an outflow at year 0. Only the tax saving on the allowance is a cash flow.
Financing is in the discount rate. Deducting interest as well charges for the money twice.
Allocated overheads are out unless the total overhead actually rises.
Evaluate every alternative, including doing nothing. Comparing only A with B would miss whether replacing is worth it at all.