Question

A manufacturing company is evaluating two options for new equipment to introduce a new product to its suite of goods. The details for each option are provided below:

Option 1 

$65,000 for equipment with useful life of 7 years and no salvage value. 

Maintenance costs are expected to be $2,700 per year and increase by 3% in Year 6 and remain at that rate. 

Materials in Year 1 are estimated to be $15,000 but remain constant at $10,000 per year for the remaining years. 

Labor is estimated to start at $70,000 in Year 1, increasing by 3% each year after. 

Revenues are estimated to be: 

Year 1Year 2Year 3Year 4Year 5Year 6Year 7-   75,000   100,000   125,000   150,000   150,000   150,000

Option 2 

$85,000 for equipment with useful life of 7 years and a $13,000 salvage value 

Maintenance costs are expected to be $3,500 per year and increase by 3% in Year 6 and remain at that rate. 

Materials in Year 1 are estimated to be $20,000 but remain constant at $15,000 per year for the remaining years. 

Labor is estimated to start at $60,000 in Year 1, increasing by 3% each year after. 

Revenues are estimated to be:

Year 1Year 2Year 3Year 4Year 5Year 6Year 7-   80,000   95,000   130,000   140,000   150,000   160,000
The company’s required rate of return is 8%.
Management has turned to its finance and accounting department to perform analyses and make a recommendation on which option to choose. They have requested that the four main capital budgeting calculations be done: NPV, IRR, Payback Period, and ARR for each option.
For this assignment, compute all required amounts and explain how the computations were performed. Evaluate the results for each option and explain what the results mean. Based on your analysis, recommend which option the company should pursue.

Answer 1

		Present Value(PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=discount rate=Cost of Capital=8%=0.08
		N=Year   of Cash Flow
		ANALYSIS OF OPTION 1
		N=Year   of Cash Flow
	N	Year	0	1	2	3	4	5	6	7
	A	Investment in Equipment	-$65,000
	b	Annual Revenue		$75,000	$100,000	$125,000	$150,000	$150,000	$150,000	$150,000
	c	Maintenance Expense		-$2,700	-$2,700	-$2,700	-$2,700	-$2,700	-$2,781	-$2,781
	d	Materials expenses		-$15,000	-$10,000	-$10,000	-$10,000	-$10,000	-$10,000	-$10,000
	e	Labor Expenses		-$70,000	-$72,100	-$74,263	-$76,491	-$78,786	-$81,149	-$83,584
	f	Depreciation Expenses(65000/7)-Straight line		-$9,286	-$9,286	-$9,286	-$9,286	-$9,286	-$9,286	-$9,286	SUM
	g=b+c+d+e+f	Accounting Profit		-$21,986	$5,914	$28,751	$51,523	$49,229	$46,784	$44,350	$204,566
	h	Add : Depreciation (non cash expense)		$9,286	$9,286	$9,286	$9,286	$9,286	$9,286	$9,286
	I=g+h	Annual Operating Cash Flow		-$12,700	$15,200	$38,037	$60,809	$58,514	$56,070	$53,635
	CF=A+I	Net Cash Flow	-$65,000	-$12,700	$15,200	$38,037	$60,809	$58,514	$56,070	$53,635
		Cumulative Cash Flow	-$65,000	-$77,700	-$62,500	-$24,463	$36,346	$94,860	$150,930	$204,566	SUM
	PV=CF/(1.08^N)	Present Value(PV) of Cash Flows	-$65,000	-$11,759	$13,032	$30,195	$44,697	$39,824	$35,333	$31,296	$117,617
	NPV=Sum of PV	Net Present Value(NPV)	$117,617
		Payback Period =Period at which Cumulative cash flow is =NIL
		Payback Period =(3+(24463/60809)	3.40	Years
	IRR	Internal Rate of Return	33%	(Using IRR function over Net Cash Flow)
		Average Accounting Profit per year	29,224	(204566/7)
	ARR	Accounting Rate Of Return	45%	(29224/65000)