Plasma Ltd, makers of plasma televisions, is considering also making DVD players. They have the choice of two machines with which to make the DVD players, and both could do the job adequately. They have called upon you to assist them in deciding whether Machine A or Machine B should be purchased. Both machines are to be depreciated straight line down to a book value of zero over their entire useful life. Despite this, it is anticipated that Machine A will be sold for $8,000 and Machine B for $12,000 at the end of their useful lives. Details of each project’s cash flows are tabulated below:
|Machine A||Machine B|
|Pre-Tax Net Annual Inflow (these cash flows occur at the end of the year)||$160,000||$210,000|
|Machine Life||10 years||12 years|
In addition to the cash flow information, you have also been provided with the following details:
- The corporate tax rate is 30%;
- Tax is payable annually in arrears (ie tax is paid on profits one year after it is earned);
- The project is in an industry which is 15% less risky than the industry in which the firm currently operates;
- Plasma Ltd currently has a beta of 1.7;
- The market risk premium is 10% p.a.; and,
- The expected return on the market is 18% p.a.
Given this information, which machine, if any, do you recommend Plasma Ltd purchase? In providing your answer, explain why you have made your recommendation.
Students are to answer ALL parts of this question:
You are the Chief Financial Officer for a major Australian mining company called ABC Mining. As a result of the booming commodity prices over the last year, your company is expecting to have a surplus of almost $20 million cash on hand at the end of September. The Board of Directors of ABC Mining wants you to invest the cash for a period of 90 days. The September 90-day BAB futures contract is currently trading at 92. Given this information, answer all three of the following questions:
- Advise the Board of ABC Mining how they can lock in an interest rate, and show that the strategy works if interest rates rise or fall.
- How could ABC Mining take advantage of any favourable movements in interest rates, while insuring that they are protected against adverse movements? Again, be sure to show that strategy works if interest rates rise or fall.
- Detail any advantages or disadvantages from using the strategy you have devised in part b) as compared with part a).