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BH Tinto is a large mining firm considering the purchase of a new drilling machine. The machine will be used to drill for iron ore at an existing...

BH Tinto is a large mining firm considering the purchase of a new drilling machine. The machine will be used to drill for iron ore at an existing mine site in Australia. BH Tinto is one of the leading producers of iron ore and a major competitor of both BHP Billiton and Rio Tinto.

In order to narrow their drill machine search BH Tinto commissioned a market analysis at a cost of $5000 (yet to be paid). The study identified two candidate machines.

Machine A costs $100,000 and will require installation costs of $5,000. Machine A can run for six years at which time it will have a salvage value of $5,000. The machine will require initial working capital of $80,000 and will produce annual revenues of $150,000 and cash operating expenses of $102,000. The salesman for Machine A is offering a loan at 10% per annum compounded monthly for the 6 year life of the machine.

Machine B can be purchased for $150,000 and requires installation costs of $4,000. The machine will require initial working capital of $70,000 and will generate annual revenues of $155,000 and cash expenses of $95,000. Its expected salvage value at the end of its ten-year life is $2,000.

The tax rate for the corporation is 30% and the company policy is to depreciate assets (including installation costs) to zero using the straight line method. BH Tinto estimates the covariance between the ASX200 and BH Tinto to be .09. The standard deviation of ASX200 returns is 25% and the standard deviation of BH Tinto is 35%. The expected return on the ASX 200 is 12% and the risk free rate is 7%. The firm is 100% equity financed.

Which Machine should BH Tinto choose and why (show all working). You need to report to the Board of Directors on the viability of this investment, including a clear explanation of the cash flows under analysis. The Board consists of a cross section of smart people but some have little or no finance training so your report needs to fully describe and justify the evaluation techniques and your final decision.

This question was asked on Apr 30, 2010.

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