Case Study:
XYZ plc operates in the paint industry. XYZ is considering to renew its technology, and to do so, a new machine needs to be bought. There are two types of machines. Machine 1 costs £10,000 and has a 3 year lifetime. Machine 2 costs £1,000 and has a 2 year lifetime. Both machines have nil scrap values at the end of their lifetimes. Also, machines 1 and 2 are the only machines available in the paint business for the next 20 years.
Technology renewal by machine 1 and technology renewal by machine 2 will generate the same risk for XYZ plc. The firm would finance its technology renewal by 60% equity and 40% riskless debt. The riskless interest rate is 5% per annum. XYZ has a dividend payout ratio of 30%, and the rate of return on reinvested funds is typically 11%. Both figures are expected to remain unchanged in the future. XYZ has also announced a dividend of £20,000 for next year and the market capitalization of the company is now £2,000,000.
The cash flows generated by machine 1 are given by:
|
Year
|
0
|
1
|
2
|
3
|
|
Capital expenditure
|
-10,000
|
|
|
|
|
Revenues
|
|
5,000
|
5,000
|
5,000
|
|
Costs
|
|
1,000
|
1,000
|
1,000
|
The cash flows generated by machine 2 are given by:
|
Year
|
0
|
1
|
2
|
|
Capital expenditure
|
-1,000
|
|
|
|
Revenues
|
|
1,400
|
1,400
|
|
Costs
|
|
600
|
600
|
a) If XYZ is operating out of a tax-exempt zone, which of the two machines, if any, should the company choose to renew its technology? Support your answer with the necessary calculations.
b) Suppose now that the company is not tax-exempt. Effective rate of corporate tax is 40% and is paid in the same year as profits are declared. Machines depreciate over their lifetimes straight line. How does taxation affect your answer to a)? Support your answer with the necessary calculations.