Question

Fruit-To-Go (FTG) processes fruit for shipping overseas.

FTG commissioned a study to look into the feasibility of changing the packaging of the fruit from cans to sealed bags. The Consultant charged $54,000 for the report.

The report concluded that the new packaging will increase sales and reduce some operating costs.

The new packaging machinery will cost $1,100,000. The new machine is expected to last 5 years. The Taxation Office advise the life of the machine, for tax purposes, is 4 years.

The old canning machinery was purchased 2 years ago for $800,000 and was being depreciated at $200,000 and will be for the next 2 years. The old machine could be sold today for $260,000. In 5 years it will be worth nothing.

Installing the new machine will require staff training (a tax deductible expense) of $35,000 before production can commence. Due to the lower cost of the bags Inventory required will be reduced by $80,000 for the life of the project.

The new sales of bagged fruit is expected to be $700,000 in Year 1 rising by 15% for 2 years then 0% for the rest of the life of the project. Variable Costs associated with the new packaged fruit are 50% of sales.

Canned fruit production will be discontinued. Sales of canned fruit were static at $450,000 with variable costs of $225,000 (50% of Sales).

The new equipment is very hi-tech. Maintenance costs are expected to be higher at $44,000 per year. Maintenance costs on the old machine were $30,000 per year.

The lighter packaging will reduce annual freight cost significantly from $250,000 to $100,000 per year.

Fixed costs are expected to remain at $320,000 per year.

At the end of the project the new machinery can be sold for $275,000.

Notes:

FTG will borrow the full Year 0 funds using a secured five-year interest-only loan at an interest rate of 10% per annum to finance the new equipment.

The company tax rate is 30%.

The required rate of return is 12.5%.

Requirement:

If NPV = 198948

IRR = 19.93%

Profitability Index = 1.227

Payback period = 4 years

Please give short explanation on how to make investing decision. (about 500 words) （25Marks）

Answer 1

Investing decision can be made on the basis of NPV, IRR, Profitability Index, payback period.

NPV: A Project can be accepted if it's NPV is positive. If NPV is negative, it means loss to company, therefore project should not be accepted. If NPV is equal to 0, means there is neither profit nor loss. If NPV is positive, It means present value of cash inflows is more than cash outflow. In this case NPV is 198948. It is positive, therefore project could be accepted.

IRR: It is the rate at which present value of cash inflows is equal to present value of cash outflow. Internal Rate of Return should be more than the company Cost of Capital or Sharesholder's required rate of return, to accept the project. It means that the return earned by the company from the project is more than the cost associated with it. If IRR is less than cost of capital, project should not be accepted because it means that the cost incurred by the company is more than the return it is getting from the project. In this case IRR is 19.93%, while required rate of return is 12.5%. Thus project can be accepted.

Profitability Index (PI): Profitability Index is calculated by dividing present value of cash inflows by Initial investment. It indicates the ratio of cash inflows to cash outflow or the initial investment. If PI is more than 1, accept the project, if PI is less than 1, reject the project, if PI is equal to 1, indifferent. Since PI is 1.227, means it is more than 1. Project should be accepted.

Payback period: It is the period by which the cost incurred can be recovered from the project inflows. It is calculated by dividing initial investment by cash inflows, without considering the time value of money. Payback period should be less than the projects life, because only then, the company will be able to earn profits. Till payback period, company is recovering it's costs. After payback period, it is a post payback period profit. If payback period is more than the project's life, it means that the firm is incurring losses and is not even able to recover it's costs. In this case, payback period is 4 years, while the life of the project is 5 years. Payback period is less than the project's life, therefore project should be accepted.

Sometimes there could be conflict between NPV and IRR, in such a situation, decision should be made based on NPV because it is more realistic and accurate.