Question

Bee LLC is considering purchasing equipment to boost its business. Given the information below, conduct the required capital budgeting analysis to offer your recommendation. Use five of the following seven methods. Please detail any assumptions made and show your calculations for your recommendation.

• Net Present Value
• Internal Rate of Return
• Modified Internal Rate of Return
• Profitability Index
• Payback Period
• Discounted Payback Period
• Average Accounting Return

Finally, calculate DeltaNPV/DeltaPrice.

Case     

To purchase the equipment, Bee LLC incurs the following costs:

Equipment purchase price          $35,700,000    

Equipment useful life           5 years, Straight Line Depreciation Rate 20% per year

Equipment Salvage value       $4,670,000       

Required R&D                  $1,200,000, to choose the right equipment

Marketing study                $450,000, to ascertain market potential                          

Bee LLC intends to produce a unique gadget with the following cost structure:

Unit Price                                                   $525

Unit Variable Cost                                          $310

Fixed Cost                                              6,200,000

Tax Rate                                                      30%

Estimate of the Annual Net Working Capital of Sales      25%

Required Return                                             15%

The company’s projections for sales are shown below:

Projected Sales    Year +1             Year +2             Year +3             Year +4             Year +5

Sales(units)           75,000             98,000              115,000             105,000              65,000

Answer 1

R & D expenses, Marketing study expenses will not be included in calculation of cost of investment. Only the price of equipment will be taken as cost of investment

a. Net Present Value

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
a. Sales	75000	98000	115000	105000	65000
b. Unit price	525	525	525	525	525
c. Sales Value (a * b)	39375000	51450000	60375000	55125000	34125000
d. Variable cost	310	310	310	310	310
e. Contribution per unit (b - d)	215	215	215	215	215
f. Contribution (a * e)	16125000	21070000	24725000	22575000	13975000
g. Fixed cost	6200000	6200000	6200000	6200000	6200000
h. Depreciation (35,700,000 * 20%)	7140000	7140000	7140000	7140000	7140000
i. Change in Working capital	0	3018750	2231250	-1312500	-5250000
j. Earnings before tax (f - g - h - i)	2785000	4711250	9153750	10547500	5885000
k. Tax @ 30%	835500	1413375	2746125	3164250	1765500
l. Earnings after tax (j - k)	1949500	3297875	6407625	7383250	4119500
m. Cash flow after tax (l + h)	9089500	10437875	13547625	14523250	11259500
n. Discounting factor @ 15%	0.869	0.756	0.657	0.572	0.497
o. Present Value	7898776	7891034	8900790	8307299	5595972
p. Total present value					38593869
q. Present Value of salvage value after tax (4,670,000 * 0.497 * [1 - 0.3])					1624693
r. Present value of cash inflows (p + q)					40218562
s. Cost of equipment					35700000
Net Present Value (r - s)					4518562

Working Note: Calculation of change in working capital

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Sales	39375000	51450000	60375000	55125000	34125000
Working capital (25% of sales)	9843750	12862500	15093750	13781250	8531250
Change in working capital	0	3018750	2231250	-1312500	-5250000

Change in working capital is calculated by subtracting amount of working capital of year 1 from year 2, year 2 from year 3 and so on. It is assumed that there is no change in working capital in year 0 and year 1.

b. Internal Rate of Return

At IRR, NPV = 0

0 = -35700000 + 9089500 / ( 1 + IRR ) + 10437875 / ( 1 + IRR ) ^ 2 + 13547625 / ( 1 + IRR ) ^ 3 + 14523250 / ( 1 + IRR ) ^ 4 + 11259500 / ( 1 + IRR ) ^ 5

Thus IRR = 18.90%

c. Profitability Index

Profitability Index = Present value of cash inflows / Initial Investment

= 40218562 / 35700000

= 1.13

d. Payback Period

Year	Cash flow	Cumulative cash flow
0	-35700000	-35700000
1	9089500	-26610500
2	10437875	-16172625
3	13547625	-2625000
4	14523250	11898250
5	11259500	23157750

Thus payback period will between year 3 and 4

Payback period = 3 + (2625000 / 14523250) = 3.18 years

e. Average Accounting Return (ARR)

ARR = Average net profit / Average Investment * 100

Average net profit = (1949500 + 3297875 + 6407625 + 7383250 + 4119500) / 5 = 4631550

Average investment = 35700000

ARR = 4631550 / 35700000 * 100 = 12.97%