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In: Economics

An olive oil factory requires a fixed capital investment of $3,000,000 and a working capital of...

An olive oil factory requires a fixed capital investment of $3,000,000 and a working capital of $250,000. The average annual cost of production is $1,200,000 whereas the average annual income from sales is $2,000,000. The tax rate on profits is known to be 15% and the rate of interest is 10%. The expected lifetime of the equipment is 15 years and the annual rate of depreciation is 6% of the initial value. a)Calculate the rate of return on investment. Comment on the investment’s feasibility. b)Calculate the payout period by neglecting the time value of money. Comment on the investment’s feasibility. c)Calculate the payout period by considering the time value of money. Comment on the investment’s feasibility.

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Expert Solution

Sales 2000
Production cost 1200
Depreciation 180
Profit before tax 620
Tax 93
Profit after tax 527
Profit after tax 527
Add: Depreciation 180
Less: Changes in working capital 250
Cash flow from operations 457
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Cash Flows -3000 457 457 457 457 457 457 457 457 457 457 457 457 457 457 457
IRR 12.70%
As IRR is greater than rate of interest, investment looks feasible
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Cumulative Cash flows -3000 -2543 -2086 -1629 -1172 -715 -258 199 656 1113 1570 2027 2484 2941 3398 3855

Payout period is between year 6 and year 7, as cumulative cash flows are converting positive in year 7.

To be exact the payout period is 6 + 258/457 = 6.56 years

The invested amount is received back in 6.56 years, which looks good.

Discounted cash flows (3,000.00) 415.45 377.69 343.35 312.14 283.76 257.96 234.51 213.19 193.81 176.19 160.18 145.61 132.38 120.34 109.40
Cumulative discounted cash flows (3,000.00) (2,584.55) (2,206.86) (1,863.51) (1,551.37) (1,267.61) (1,009.65) (775.13) (561.94) (368.13) (191.93) (31.76) 113.86 246.23 366.58 475.98

Using 10% discount rate, above are the discounted cash flows

Cumulative discounted cash flows are converting positive in 12th year.

Discounted payout period is somewhere between 11 and 12 year.

To be exact 11 + 31.76/145.61 = 11.22

We are able to acheive the desired return of 10% in 11.22 years, while life of project is 15 years, which makes the investment feasible.  

Rahul Sunny answered 2 years ago
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