Question

Submit a written paper which is 3-4 pages in length (no more than 4-pages), exclusive of the reference page. Your paper should be double spaced in Times New Roman (or its equivalent) font, which is no greater than 12 points in size. The paper should cite at least three sources in APA format. One source can be your textbook.

Please describe the circumstances of the following case study and recommend a course of action. Explain your approach to the problem, perform relevant calculations and analysis, and formulate a recommendation. Ensure your work and recommendation are thoroughly supported.

Case Study:

A manufacturing company is evaluating two options for new equipment to introduce a new product to its suite of goods. The details for each option are provided below:

Option 1

• $65,000 for equipment with useful life of 7 years and no salvage value.
• Maintenance costs are expected to be $2,700 per year and increase by 3% in Year 6 and remain at that rate.
• Materials in Year 1 are estimated to be $15,000 but remain constant at $10,000 per year for the remaining years.
• Labor is estimated to start at $70,000 in Year 1, increasing by 3% each year after.

Revenues are estimated to be:

Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
-	75,000	100,000	125,000	150,000	150,000	150,000

Option 2

• $85,000 for equipment with useful life of 7 years and a $13,000 salvage value
• Maintenance costs are expected to be $3,500 per year and increase by 3% in Year 6 and remain at that rate.
• Materials in Year 1 are estimated to be $20,000 but remain constant at $15,000 per year for the remaining years.
• Labor is estimated to start at $60,000 in Year 1, increasing by 3% each year after.

Revenues are estimated to be:

Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
-	80,000	95,000	130,000	140,000	150,000	160,000

The company’s required rate of return and cost of capital is 8%.

Management has turned to its finance and accounting department to perform analyses and make a recommendation on which option to choose. They have requested that the four main capital budgeting calculations be done: NPV, IRR, Payback Period, and ARR for each option.

For this assignment, compute all required amounts and explain how the computations were performed. Evaluate the results for each option and explain what the results mean. Based on your analysis, recommend which option the company should pursue.

Superior papers will:

• Perform all calculations correctly.
• Articulate how the calculations were performed, including from where values used in the calculations were obtained.
• Evaluate the results computed and explain the meaning of the results, including why certain measurements are more accurate than others.
• Recommend which option to pursue, supported by well-thought-out rationale, and considering any other factors that could impact the recommendation.

Answer 1

Option 1.

	Intial Cash outflow (in $)	Revenue(in $)	Maintenance Cost(in $)	Materials(in $)	Labour(in $)	depreciation(in $)	Net income(in $)	Cash flows (in $)(Net income +depreciation)
Year 0	(65,000)
Year 1		75,000	2,700	15,000	70,000	9286	(21,986)	(12,700)
Year 2		100,000	2,700	10,000	72,100	9,286	5,914	15,200
Year 3		125,000	2,700	10,000	74,263	9,286	28,751	38,037
Year 4		150,000	2,700	10,000	76,491	9,286	51,523	60,809
Year 5		150,000	2,700	10,000	78,786	9,286	49,228	58,514
Year 6		150,000	2,781	10,000	81,150	9,286	46,783	56,069
Year7		150,000	2,781	10,000	83,585	9,286	44,348	53,634

Payback Period

	Cashinflows(in $)	Cummulative Cashflows(in $)
Year 0	(65,000)	(65,000)
Year 1	(12,700)	(77,700)
Year 2	15,200	(62,500)
Year 3	38,037	(24,463)
Year 4	60,809	36,346
Year 5	58,514	94,860
Year 6	56,069	150,929
Year 7	53,634	204,563

Payback Period ==> 3 years + $24,463 / $60,809

==> 3.4 years

Accounting rate of return

Year	Net income(in $)
1	(21,986)
2	5,914
3	28,751
4	51,523
5	49,228
6	46,783
7	44,348

Total net profit ==> $204,561

Average Net profit ==> $29,223

Accounting rate of return

  ==> $29,223 / $65,000

==> 44.96%

Net present Value :

Year	Cashflows(in $)	PVF @8%	Discounted cash flows(in $)
0	($65,000)	1	($65,000)
1	($12,700)	0.9259	($11,759)
2	$15,200	0.8573	$13,031
3	$38,037	0.7938	$30,194
4	$60,809	0.735	$44,695
5	$58,514	0.6806	$39,825
6	$56,069	0.6302	$35,335
7	$53,634	0.5835	$31,295
		Total	$117,616

Net Present Value ==> $117,616

Option 2

Year	Intial Cash outflow(in $)	Revenue(in $)	Maintenance Cost(in $)	Materials(in $)	Labour(in $)	depreciation(in $)	Net income(in $)	Cash flows (in $)(Net income +depreciation)
0	($85,000)
1		$80,000	$3,500	$20,000	$60,000	$10,286	($13,786)	($3,500)
2		95000	$3,500	$15,000	$61,800	$10,286	$4,414	$14,700
3		$130,000	$3,500	$15,000	$63,654	$10,286	$37,560	$47,846
4		$140,000	$3,500	$15,000	$65,564	$10,286	$45,650	$55,936
5		$150,000	$3,500	$15,000	$67,531	$10,286	$53,683	$63,969
6		$160,000	$3,605	$15,000	$69,557	$10,286	$61,552	$71,838
7		$160,000	$3,605	$15,000	$71,644	$10,286	$59,465	$69,751
7		$13,000						$13,000

Payback period :

Year	Cashinflows(in $)	Cummulative Cashflows(in $)
0	($85,000)	($85,000)
1	($3,500)	($88,500)
2	$14,700	($73,800)
3	$47,846	($25,954)
4	$55,936	$29,982
5	$63,969	$93,951
6	$71,838	$165,789
7	$82,751	$248,540

Payback Period ==> 3 years + $25,954 / $55,936

==> 3.46 years

Accounting rate of return :

Year	Net income(in $)
1	($13,786)
2	$4,414
3	$37,560
4	$45,650
5	$53,683
6	$61,552
7	$59,465

Total net profit ==> $248,538

Average Net profit ==> $35,505.43

Accounting rate of return ==> Average net profit / (Intial investment - scarp value)

==> $35,505.43 / ($85000 - $13,000)

==> 49.31%

NPV :

Year	Cashflows(in $)	PVF @8%	Discounted cash flows(in $)
0	($85,000)	1	($85,000)
1	($3,500)	0.9259	($3,241)
2	$14,700	0.8573	$12,602
3	$47,846	0.7938	$37,980
4	$55,936	0.735	$41,113
5	$63,969	0.6806	$43,537
6	$71,838	0.6302	$45,272
7	$69,751	0.5835	$40,700
	$13,000	0.5835	$7,585.50
		Total	$140,550

Net Present Value ==> $140,550

Based on the above Option 2 is better.

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