Investment in a new manufacturing machine: important considerations

Virtual CFO Services
Introduction

Here we explore the question of whether it is as easy as buying a new manufacturing machine because the old one has served its purpose or it is time for expansion and new manufacturing machinery may be required. Investment in a new machine comes with challenges. A new purchase should be made in line with the strategic view of a manufacturing company. From the outset, the distinction should be made between an expansion or replacement of manufacturing machinery. Both options carry different risk profiles and may make estimating cash flow harder.

Ultimately what you are trying to determine is whether your new machine will bring about the maximum profitable results. On the other hand, there may be an alternative option that suits you better. Alternatives may for e.g. be, selecting machine A over machine B or buying vs leasing.

Factors to consider when making an investment decision in a new manufacturing machine include

Cash flow considerations

To be more specific, which cash implications (both inflow and outflows) will the investment in a new machine bring about.

Some considerations may be:

  • The purchase cost of a new machine
  • The selling price proceeds of a machine you are replacing
  • The tax effect of selling an old machine
  • Incremental operating cash flows
  • The additional working capital commitments and or returns that the new machine will lock-in
  • End of investment cash flows such as selling the new asset at the end of its useful life
Taxation considerations

Manufacturing assets are allowed to deduct manufacturing tax allowances in terms of section 12C. There is a normal allowance that caters for a 20% deduction per year. Alternatively, an accelerated tax allowance that caters for a 40% first year and 20% for the next three years

Recoupmens in terms of section 8(4)(a) and or scrapping allowances in terms of section 11(0) bears a cash flow implication and should be modelled into the investment decision.

Capital Gains Tax implications may arise in situations where the asset was disposed of for more than its cost price. This will trigger the inclusion of 80% for manufacturing companies of the capital gain made into its taxable income.

Opportunity cost considerations

The opportunity forgone should also be included as a cost in the investment of new machinery. Opportunity cost is associated with choosing one alternative over another e.g. in the event that a new expansion would decrease demand on an existing production process. The cost of loss in demand should be included in the model.

Time value of money considerations

The value of a manufacturer’s investment in new equipment will be determined by both the size of the future cash flows generated by the new investment and the timing of those cash flows. It’s more favourable to receive cash flows sooner rather than later and therefore a higher premium can be placed on an investment that generates a greater return in a shorter period.

Conclusion

Investment in a new manufacturing machine requires careful consideration between alternative and financial analysis as the wrong investment decision may end up costing the company. Information is key in making decisions and being able to gather the correct information from reliable sources will be as important as the analysis itself.

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