Question

The case – Macarony Inc.
Macarony Inc. is considering making a capital expenditure for a project that would have
an eight-year life and require a $2,400,000 investment in equipment.
At the end of eight years, the project would terminate and the equipment would have no
salvage value.
The project would provide operating income each year as follows:
Sales $3,000,000
Variable expenses 1,800,000
Contribution margin 1,200,000
Fixed expenses:
Advertising, salaries, and other fixed out-of-pocket costs $700,000
Depreciation 300,000
Total fixed expenses 1,000,000
Operating income $ 200,000
The company’s discount rate is 12%.
Required
1. Compute the net annual cash inflow from the project.
2. Compute the project’s net present value. Is the project acceptable?
3. Find the project’s IRR to the nearest whole percentage point.
4. Compute the project’s payback period.
5. Compute the project’s simple rate of return.
6. Explain which department in the organization hierarchy is responsible for making
a capital budget decision, a purchase of the asset, a disposal of the scrap.
7. What would be your decision point if a new equipment require a layoff of 24
direct labour workers?

Answer 1

Answer:

1. Net annual Cash inflow

Net annual Cash inflow = Operating Income + Depreciation (Non-cash expense)

                                            = $200,000 + $300,000

                                            = $500,000

2. Net Present Value

Net Present Value = Present value of total cash inflows - Present value of total cash outflows

Present value of total cash outflows = Cost of the project = $2,400,000

Present value of total cash inflows

Net Present Value = Present value of total cash inflows - Present value of total cash outflows                

                                  = $2,484,000 - $2,400,000

                                  = $84,000

3. Internal rate of return (IRR)

At IRR the Net Present value is Zero . So we shall compute Net present value

Let us compute NPV at 13%

Net Present Value = Present value of total cash inflows - Present value of total cash outflows

Present value of total cash outflows = Cost of the project = $2,400,000

Present value of total cash inflows

Net Present Value = Present value of total cash inflows - Present value of total cash outflows                

                                  = $2,399,500 - $2,400,000

                                  = ($500)

IRR = 12% + [NPV at 12% (13% - 12%)] / (NPV at Lower rate - NPV at Higher rate)

        = 12% + [$84,000 (1%)] / ($84,000 - {-500})

        = 12% + ($840) / ($84,000+$500)

        = 12% + ($840 / $84,500)

        = 12% + 0.994%

        = 12.994%

        = 13%

The IRR is 13% (as it is mentioned to round off to nearest whole percentage point)

4. Payback Period

Payback Period = Initial Investment / Net Annual cash inflow

                             = $2,400,000 / $500,000

                             = 4.8 years