Question

A food processing shop in Accra (Biem) is considering adding a new line and you are hired to conduct the capital budgeting analysis. Biem needs to increase production capacity to meet increasing demand for an existing products, ‘Quado’, which is used in food processing. A new machine, with a useful life of four years and a maximum output of 600,000 kg of Quado per year, could be bought for GHC 800,000, payable immediately. The scrap value of the machine after four years would be GHC30,000. Biem is in the 25 percent tax bracket. Forecast demand and production of Quado over the next four years is as follows:

Year                    1             2           3              4
Demand (kg)     1.4m      1.5m     1.6m       1.7m
where m is million.

Existing capacity for Quado is limited to one million kilograms per year. The current selling price of Quado is GHC8.00 per kilogram and variable cost of materials is GHC 5.00 per kilogram. Other variable costs of production are GHC 1.90 per kilogram. Fixed costs of production associated with the new machine would be GHC 240,000 in the first year of production, increasing by GHC 20,000 per year in each subsequent year of operation.

Biem charges depreciation of 25 percent on straight line basis and this is tax allowable. Biem uses its after-tax weighted average cost of capital of 10 percent when appraising investment projects. Is the proposed machine purchase suitable for Biem? What will your decision be if the discount rates are 5 percent, 15 percent 20 per cent and 25 percent?

Answer 1

	Cash flow from operation
		Year 1	Year 2	Year 3	Year 4
	Incremental Sale	400000	500000	600000	700000
	Sales (Qty *Sale price)	3200000	4000000	4800000	5600000
	Less : Variable cost( Qty*Variable cost)	-2000000	-2500000	-3000000	-3500000
	Fixed cost	-240000	-260000	-280000	-300000
	Depreciation (800000-30000)/4	-192500	-192500	-192500	-192500
	Scrap Value				30000
	Net Income before tax	767500	1047500	1327500	2337500
	Less : Tax @ 25%	191875	261875	331875	584375
	Net Income after tax	575625	785625	995625	1753125
	Add : Depreciation	192500	192500	192500	192500
	Free cash flow from operation	768125	978125	1188125	1945625
	If Discount rate is 10%, the NPV would be
	Year	Cash flow	Discounting factor @ 10%	Present value
	0	-800000	1	-800000
	1	768125	0.909091	698295.5
	2	978125	0.826446	808367.8
	3	1188125	0.751315	892655.9
	4	1945625	0.683013	1328888
	NPV			2928207
	Since the NPV is $ 2928207, the machine is suitable for Biem
	If Discount rate is 5%, the NPV would be
	Year	Cash flow	Discounting factor @ 5%	Present value
	0	-800000	1	-800000
	1	768125	0.952381	731547.6
	2	978125	0.907029	887188.2
	3	1188125	0.863838	1026347
	4	1945625	0.822702	1600671
	NPV			3445753
	Since the NPV is $ 3445753, the machine is suitable for Biem
	If Discount rate is 15%, the NPV would be
	Year	Cash flow	Discounting factor @ 15%	Present value
	0	-800000	1	-800000
	1	768125	0.869565	667934.8
	2	978125	0.756144	739603
	3	1188125	0.657516	781211.5
	4	1945625	0.571753	1112417
	NPV			2501167
	Since the NPV is $ 2501167, the machine is suitable for Biem
	If Discount rate is 20%, the NPV would be
	Year	Cash flow	Discounting factor @ 20%	Present value
	0	-800000	1	-800000
	1	768125	0.833333	640104.2
	2	978125	0.694444	679253.5
	3	1188125	0.578704	687572.3
	4	1945625	0.482253	938283.7
	NPV			2145214
	Since the NPV is $ 2145214, the machine is suitable for Biem
	If Discount rate is 25%, the NPV would be
	Year	Cash flow	Discounting factor @ 25%	Present value
	0	-800000	1	-800000
	1	768125	0.8	614500
	2	978125	0.64	626000
	3	1188125	0.512	608320
	4	1945625	0.4096	796928
	NPV			1845748
	Since the NPV is $ 1845748, the machine is suitable for Biem