Question

During 2017, the management of Brogan plc identified a project that that will enable a new product to be sold and you have been asked to evaluate the new investment.

New plant and equipment will be purchased by the end of 2017 and this will cost £450 000. The new plant and equipment will be depreciated for tax purposes, using the straight-line method over a period of three years, which is the expected life of the machine. After three years, it is expected that the machine will have no scrap value.

As a result of this new product being manufactured and sold, the company’s working capital will increase by £20 000 at the end of 2017 and will increase to £35 000 in 2018 and remain at this level until the production ceases.

The new product will sell for £40 per unit and the variable cost is expected to be 25 per cent of the selling price. The fixed costs, excluding the depreciation charge will be £60 000 and this will increase by 10 per cent each year.

The sales of the new product are expected to be

2018                12 000 units

2019                20 000 units

2020                20 000 units

Tax is payable at 30 per cent and will be paid in the year after the profit is generated,

The required rate of return is 10 per cent

Required:

1. What will be the effect on the company’s profit if the new machinery and equipment is purchased?

  

2. Using the Discounted Cash Flow approach, determine if the company should invest in the new plant?

  

(c)        What the other methods are available to evaluate investment projects and discuss the issues that must be considered if these methods are used to make an investment decision.

Answer 1

a)

b)

Discounted Cashflow

here n = year no (example 1,2 and 3)

c) other methods are available to evaluate investment projects

1) Payback Period:- The payback period is the time in which the initial outlay of investment is expected to be recovered through the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.

Advantages of payback period are:

1. Payback period is very simple to calculate.
2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are considered more uncertain, payback period provides an indication of how certain the project cash inflows are.
3. For companies facing liquidity problems, it provides a good ranking of projects that would return money early.

Disadvantages of payback period are:

1. Payback period does not take into account the time value of money which is a serious drawback since it can lead to wrong decisions. A variation of payback method that attempts to address this drawback is called discounted payback period method.
2. It does not take into account, the cash flows that occur after the payback period. This means that a project having very good cash inflows but beyond its payback period may be ignored.

2)Internal rate of return (IRR) is the discount rate at which the net present value of an investment is zero. IRR is one of the most popular capital budgeting technique.IRR is a discounted cash flow (DCF) technique which means that it incorporates the time value of money. The initial outlay/investment in any project must be compensated by net cash flows which far exceed the initial investment. The higher those cash flows when compared to the initial outlay, the higher will be the IRR and the project is a promising investment.

Internal rate of return is one of the most popular capital budgeting tools, but theoretically, net present value, a measure of absolute value added by a project, is a better indicator of a project’s feasibility. This is because sometimes where the cash flows are unconventional i.e.. there are net cash outflows other than the initial investment outlay, we may get multiple results for internal rate of return. This phenomenon is called multiple IRR problem.

Internal rate of return technique assumes that all project cash flows are reinvested at the internal rate of return, which is rarely the case because new investment opportunities are seldom readily available.

3)Accounting rate of return (also known as the simple rate of return) is the ratio of estimated accounting profit of a project to the average investment made in the project. ARR is used in investment appraisal.

Accept the project only if its ARR is equal to or greater than the required accounting rate of return. In case of mutually exclusive projects, accept the one with highest ARR.

Advantages

1. Like payback period, this method of investment appraisal is easy to calculate.
2. It recognizes the profitability factor of investment.

Disadvantages

1. It ignores the time value of money. Suppose, if we use ARR to compare two projects having equal initial investments. The project which has a higher annual income in the latter years of its useful life may rank higher than the one having higher annual income in the beginning years, even if the present value of the income generated by the latter project is higher.
2. It can be calculated in different ways. Thus there is a problem of consistency.
3. It uses accounting income rather than cash flow information. Thus it is not suitable for projects which had high maintenance costs because their viability also depends upon timely cash inflows.

4)Profitability index: Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project.

Accept a project if the profitability index is greater than 1, stay indifferent if the profitability index is 1 and don't accept a project if the profitability index is below 1.

Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing since it helps in ranking projects based on their per dollar return.