NPV and payback calculations

You are employed as the assistant accountant in your company and you are currently working on an appraisal of a project to purchase a new machine. The machine will cost £55 000 and will have a useful life of three years. You have already estimated the cash flows from the project and their taxation effect, and the results of your estimates can be summarized as follows:

Year 1

Year 2

Year 3

Post-tax cash inflow

£18000

£29000

£31000

Your company uses a post-tax cost of capital of 8% to appraise all projects of this type.

Task 1

(a) Calculate the net present value of the proposal to purchase the machine. Ignore the effects of inflation and assume that all cash flows occur at the end of the year.

(b) Calculate the payback period for the investment in the machine.

Task 2

The marketing director has asked you to let her know as soon as you have completed your appraisal of the project. She has asked you to provide her with some explanation of your calculations and of how taxation affects the proposal.

Prepare a memorandum to the marketing director which answers her queries. Your memorandum should contain the following:

(a) your recommendation concerning the proposal;

(b) an explanation of the meaning of the net present value and the payback period;

(c) an explanation of the effects of taxation on the cash flows arising from capital expenditure.

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