In: Finance
Newlands Brewery is evaluating a new product line for the
production of two new cider brands for the young affluent target
market. The brewery is currently operating at its optimal capacity
and it will have to invest in an expansion for new machinery and
production space. The expected cash flows for the two cider brands
are:
Project Cider A, Cashflows are as follows , Year 0=(25 000), Year
1=12 900, Year 2=10 900, Year 3 =8 300 and year 4=7 240.
Project Cider B, Cashflows are as follows , Year 0=(13 500), Year 1=7 230, Year 2=8 200, Year 3 =8 600 and year 4=5 400
Also the expected net income figures for the new product line are as follows
Project Cider A net incomes Year 1=6 728, Year 2=4 800, Year 3 =2 009 and Year 4= 7 420
Project Cider B net incomes Year 1=3 855, Year 2=4 725, Year 3=5 255 and Year 4 =1 864
Consider the following information:
• The average book value for Cider A project is R12,500,000
• The average book value for Cider B project is R6,800,000
• Management requires 15 percent for the project to go ahead based
on accounting rate of return perspective
• The discount rate for a project of similar risk level is 10
percent
• Management requires a minimum payback of 1.75 years for the type
of risk associated with this project
Required:
Taking into consideration that the two projects are independent and
no scaling issues, what should Newlands Brewery do? Your answer
should be supported by the analysis of the following
calculations:
• Payback method
• Discounted payback method
• Accounting rate of return (using averages)
• Net present value
• Internal rate of return
• Profitability index
Now consider the presence of scaling issue, which project should
Newland Brewery consider?
project cider A | project cider B | ||||
Year 0 | -25000 | -13500 | |||
Year 1 | 12,900.00 | 7,230.00 | |||
Year 2 | 10900 | 8200 | |||
Year 3 | 8300 | 8600 | |||
Year 4 | 7240 | 5400 | |||
Total cash flows | 14340 | 15930 | |||
(A ) | Payback period ( in years ) | 1.74 | 0.85 | ||
For project cider A | |||||
PV @ 10 % | |||||
Year 0 | -25000 | -25000 | |||
Year 1 | 12900 | 11,727.27 | -13,272.73 | ||
Year 2 | 10900 | 9,008.26 | -4,264.46 | ||
Year 3 | 8300 | 6,235.91 | 1,971.45 | ||
Year 4 | 7240 | 4,945.02 | 6,916.47 | ||
Discounted Payback Period formula = Year before the discounted payback period occurs + (Cumulative cash flow in year before recovery / Discounted cash flow in year after recovery) | |||||
(B ) | Discounted payback = | 2 + .38 | 2.38 | :=2+ 4246/11180 | |
For project cider B | PV @ 10 % | ||||
Year 0 | -13500 | -13500 | |||
Year 1 | 7,230.00 | 6,572.73 | -6,927.27 | ||
Year 2 | 8200 | 6,776.86 | -150.41 | ||
Year 3 | 8600 | 6,461.31 | 6,310.89 | ||
Year 4 | 5400 | 3,688.27 | 9,999.17 | ||
Discounted Payback Period formula = Year before the discounted payback period occurs + (Cumulative cash flow in year before recovery / Discounted cash flow in year after recovery) | |||||
Discounted payback = | 2+.01 | 2.01 | :=2+ 150/10150 | ||
(C ) | Accounting rate of return | ||||
Project cider A | Project cider B | ||||
Year 1 | 6278 | 3855 | |||
Year 2 | 4800 | 4725 | |||
Year 3 | 2009 | 5255 | |||
Year 4 | 7420 | 1864 | |||
TOTAL net incomes | 20507 | 15699 | |||
Avg net income | 5126.75 | 3924.75 | |||
Investment | 25000 | 13500 | |||
ARR | 20.51 | 29.07 | |||
(D) | NET PRESENT VALUE | ||||
NPV | Project cider A | ||||
Cash flows | PV @ 10 % | 10% | |||
Year 0 | -25000 | ||||
Year 1 | 12900 | 11,727.27 | |||
Year 2 | 10900 | 9,008.26 | |||
Year 3 | 8300 | 6,235.91 | |||
Year 4 | 7240 | 4,945.02 | |||
PV OF all cash flows | 31,916.47 | ||||
NPV ( pv - initial investment | 6,916.47 | ||||
NPV | Project cider b | ||||
Cash flows | PV @ 10 % | ||||
Year 0 | -13500 | ||||
Year 1 | 7,230.00 | 6,572.73 | |||
Year 2 | 8200 | 6,776.86 | |||
Year 3 | 8600 | 6,461.31 | |||
Year 4 | 5400 | 3,688.27 | |||
PV OF all cash flows | 23,499.17 | ||||
NPV ( pv - initial investment | 9,999.17 | ||||
(D) | Internal rate of return | ||||
NPV | Project cider A | ||||
Cash flows | PV @ 23.77 % | ||||
Year 0 | -25000 | ||||
Year 1 | 12900 | 10,422.56 | |||
Year 2 | 10900 | 7,115.34 | |||
Year 3 | 8300 | 4,377.56 | |||
Year 4 | 7240 | 3,085.16 | |||
PV OF all cash flows | 25,000.61 | ||||
rate at which the NPV is zero | IRR | 23.77% | |||
NPV | Project cider b | ||||
Cash flows | PV @ 41.95 % | ||||
Year 0 | -13500 | ||||
Year 1 | 7,230.00 | 5,093.34 | |||
Year 2 | 8200 | 4,069.52 | |||
Year 3 | 8600 | 3,006.71 | |||
Year 4 | 5400 | 1,330.00 | |||
PV OF all cash flows | 13,499.58 | ||||
rate at which the NPV is zero | IRR | 41.95% |