La Forme Idéal SA is a company that makes clothing. The company is considering investing in purchasing a new machine that could be used to produce petite sizes as well. The cost of the new machine is £40,000 and it will generate revenues of £90,000 per year for five years. The operating expenses needed to generate these revenues will be in total £57,000 per year. The machine is expected to sell for £1,000 at the end of its five-year life and will be depreciated on a straight-line basis over five years to zero. The corporate tax rate is 34% and the opportunity cost of capital is 12%.

1. (i) Should the company purchase the new machine? Explain why or why not.
2. (ii) Briefly explain why the announcement of new investment is usually accompanied by a change in the firm’s share price.

First we will calculate the NPV of the investment

Cash outflow= 40,000

Cash inflow per year

Revenue= 90,000

Operating expenses= 57,000

Gross revenue= 90,000-57,000= 33,000

Depreciation per year= 40,000-1000/5= 39000/5=7,800

Net income for tax purpose= 33,000-7,800= 25,200

Tax payable= 34% of 25,200= 8,568

Net income= 25,200-8,568=16,632

Add tax saving on depreciation= 34% of 7800=2,652

Net yearly revenue= 16,632+2652= 19,284

As net revenue is same for 5 years, we will calculate the NPV of it by using PVIFA_{12% 5 years} which is= 3.6048

NPV of all cash inflows= 19,284*3.6048= 69,514.96

NPV of salvage value of 1000, we will calculate it by using NPIF_{12% 5 years} = 0.5674= 1000*0.5674= 567.40

Total PV of the project= 69,514.96+ 567.40=70,082.36

NPV of the project= 70,082.36-40,000= 30,082.36

The company should purchase the new machine as it has a net present value of 30,082.36

ii) There are many factors which effect the share price of a company and one of them is new investment. The share price generally increases when some new investment is made as the market expects increase in revenue and subsequently increase in dividend payment.