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Question one SC Co is evaluating the purchase of a new machine to produce product P...
Question one
SC Co is evaluating the purchase of a new machine to produce product P , Which has a short product life-cycle due to rapidly changing technology .The machine is expected to cost $1 million . Production and sales of product P are forecast to be as follows :
|
Year |
1 |
2 |
3 |
4 |
|
Production and sales (units/year) |
35000 |
53000 |
75000 |
36000 |
The selling price 0f product P (in current price terms )will be $20 per unit, while the variable cost of the product (in current price terms )will be $12 per unit .Selling price inflation is expected to be 5% per year. No increase in existing fixed costs is expected since SC co has spare capacity in both spare and labourterms .
Production and selling product P will call for increased investment in working capital . Analysis of historical levels of working capital within SC Co indicates that at the start of each year , investment in working capital for product P will be need to be 7% of sales revenue for that year .
SC Co pays tax of 30% per year in the year in which the taxable profit occurs ,liability to tax is reduced by capital allowances on machinery (tax –allowable depreciation ) , which SC Co can claim on a straight –line basis over the four-year period .SC Co uses a nominal (money terms ) after-tax cost of capital of 12% for investment appraisal purposes.
Required :
- Determine the after –tax cash-flows associated with the purchase of a new machine to purchase product P .(12) marks
- Calculate the net present value of the proposed investment in product P.(6) marks
- Compute the internal rate of return of the proposed investment in product P.(6)marks
- Advise on the acceptability of the proposed investment in product P and discuss the limitations of the evaluations you have carried out.(8)marks
- Discuss hoe the net present value method of investment appraisal contributes towards the objective of maximizing the wealth of shareholders .(8)marks
Solutions
Expert Solution
| NPV analysis using a nominal (money terms ) after-tax cost of capital of 12% | |||||
| Year | 0 | 1 | 2 | 3 | 4 |
| 1.Cost of machine | -1000000 | ||||
| 2.NWC reqd.(Next yr. sales*7%) | 51450 | 81805.5 | 121550.6 | 61261.52 | 0 |
| 3.Change in NWC(Previous-Current) | -51450 | -30355.5 | -39745.1 | 60289.11 | 61261.52 |
| Operating cashflows: | |||||
| 4.Production and sales (units/year) | 35000 | 53000 | 75000 | 36000 | |
| 5.Selling price/unit(20*1.05)$ so on | 21 | 22.05 | 23.1525 | 24.31013 | |
| 6.Sales $(4*5) | 735000 | 1168650 | 1736438 | 875164.5 | |
| 7.Variable cost/unit(12*1.05)& so on | 12.6 | 13.23 | 13.8915 | 14.58608 | |
| 8.Total variable cost(4*6) | -441000 | -701190 | -1041863 | -525099 | |
| 9.Depreciation | -250000 | -250000 | -250000 | -250000 | |
| 10.EBIT(6+8+9) | 44000 | 217460 | 444575 | 100065.8 | |
| 11.Tax at 30%(10*30%) | -13200 | -65238 | -133373 | -30019.7 | |
| 12.NOPAT(10+11) | 30800 | 152222 | 311202.5 | 70046.06 | |
| 13.Add back: depn.(row 9) | 250000 | 250000 | 250000 | 250000 | |
| 14.Operating cash flow(12+13) | 280800 | 402222 | 561202.5 | 320046.1 | |
| a. After –tax cash-flows associated with the purchase of a new machine | -1051450 | 250444.5 | 362476.9 | 621491.6 | 381307.6 |
| 16. PV F at 12%(1/1.12^Yr.n) | 1 | 0.89286 | 0.79719 | 0.71178 | 0.63552 |
| 17. PV at 12%(a*16) | -1051450 | 223611.2 | 288964.3 | 442365.5 | 242327.9 |
| 18. NPV at 12% (ANSWER b. ) | 145818.82 | ||||
| 19. Internal rate of return (Answer c.)(of FCF row a.) | 17.82% |
| d.Proposed investment in product P can be accepted as the NPV at the nominal cost of capital, 12% is POSITIVE |
| &the IRR, 17.82% > the nominal cost of capital, 12% |
| Limitation , with respect to the above analysis , is that it considers all the future cashflows like sales & variable costs at inflated values & not at their real value terms. |
| e.How the net present value method of investment appraisal contributes towards the objective of maximizing the wealth of shareholders |
| NPV method takes into account the entire cash flows of the project , discounts them at the cost of acquring funds for the project and arrives at the net income , at present value terms. |
| So, the project with positive cash flow , is said to add value to the company & its owners. |
Additionally for d.
| The real discount rate will be |
| (1+12%)=(1+Real rate )*(1+5%) |
| RR=((1+12%)/(1+5%))-1= |
| 6.67% |
| NPV analysis using the real rate of 6.67% cost of capital | |||||
| Year | 0 | 1 | 2 | 3 | 4 |
| 1.Cost of machine | -1000000 | ||||
| 2.NWC reqd.(Next yr. sales*7%) | 49000 | 74200 | 105000 | 50400 | 0 |
| 3.Change in NWC(Previous-Current) | -49000 | -25200 | -30800 | 54600 | 50400 |
| Operating cashflows: | |||||
| 4.Production and sales (units/year) | 35000 | 53000 | 75000 | 36000 | |
| 5.Selling price/unit--current rate-$20 | 20 | 20 | 20 | 20 | |
| 6.Sales $(4*5) | 700000 | 1060000 | 1500000 | 720000 | |
| 7.Variable cost/unit--current rate -$ 12 | 12 | 12 | 12 | 12 | |
| 8.Total variable cost(4*6) | -420000 | -636000 | -900000 | -432000 | |
| 9.Depreciation | -250000 | -250000 | -250000 | -250000 | |
| 10.EBIT(6+8+9) | 30000 | 174000 | 350000 | 38000 | |
| 11.Tax at 30%(10*30%) | -9000 | -52200 | -105000 | -11400 | |
| 12.NOPAT(10+11) | 21000 | 121800 | 245000 | 26600 | |
| 13.Add back: depn.(row 9) | 250000 | 250000 | 250000 | 250000 | |
| 14.Operating cash flow(12+13) | 271000 | 371800 | 495000 | 276600 | |
| a. After –tax cash-flows associated with the purchase of a new machine | -1049000 | 245800 | 341000 | 549600 | 327000 |
| 16. PV F at 6.67%(1/1.0667^Yr.n) | 1 | 0.93747 | 0.87885 | 0.82390 | 0.77238 |
| 17. PV at 6.67%(a*16) | -1049000 | 230430.3 | 299688.3 | 452814 | 252568.1 |
| 18. NPV at 6.67%% (ANSWER b. ) | 186500.74 |
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