|
NPV |
||||||
|
Rate |
13.8% |
|||||
|
Year |
0 |
1 |
2 |
3 |
4 |
5 |
|
Cash Flows |
– 4,800,000 |
2,080,000 |
1,200,000 |
1,930,000 |
1,105,000 |
1,245,000 |
|
Discount Factor |
1.00000 |
0.87873 |
0.77217 |
0.67854 |
0.59625 |
0.52395 |
|
Present Value |
– 4,800,000 |
1,827,768 |
926,609 |
1,309,575 |
658,860 |
652,316 |
|
NPV |
$575,129 |
|||||
|
NPV |
$575,129 |
|
Rate |
13.8% |
|||||
|
Year |
0 |
1 |
2 |
3 |
4 |
5 |
|
Cash Flows |
– 4,800,000 |
2,080,000 |
1,200,000 |
1,930,000 |
1,105,000 |
1,245,000 |
|
Discount Factor |
1.00000 |
0.87873 |
0.77217 |
0.67854 |
0.59625 |
0.52395 |
|
Present Value |
– 4,800,000 |
1,827,768 |
926,609 |
1,309,575 |
658,860 |
652,316 |
|
NPV |
$575,129 |
|||||
|
Year |
0 |
1 |
2 |
3 |
4 |
5 |
|
Cash Flows |
– 4,800,000 |
2,080,000 |
1,200,000 |
1,930,000 |
1,105,000 |
1,245,000 |
|
NPV |
$575,129 |
Using NPV function the correct way |
||||
|
Using IRR Function |
||||||
|
IRR |
19.14% |
|
Payback (normal) |
|||||||
|
Year |
0 |
1 |
2 |
3 |
4 |
5 |
|
|
Cash Flows |
– 4,800,000 |
2,080,000 |
1,200,000 |
1,930,000 |
1,105,000 |
1,245,000 |
|
|
Cumulative Owing |
– 4,800,000 |
– 2,720,000 |
– 1,520,000 |
410,000 |
1,515,000 |
2,760,000 |
|
|
PB |
2.79 |
|
Cost of Asset |
$ 4,800,000 |
||||
|
Converting Cash Flows to Accounting Profit |
|||||
|
Year |
1 |
2 |
3 |
4 |
5 |
|
Revenue |
2,080,000 |
1,200,000 |
1,930,000 |
1,105,000 |
1,245,000 |
|
Salvage Value |
– 325,000 |
||||
|
Depreciation |
– 895,000 |
– 895,000 |
– 895,000 |
– 895,000 |
– 895,000 |
|
Profit |
1,185,000 |
305,000 |
1,035,000 |
210,000 |
25,000 |
|
Profit |
1,185,000 |
305,000 |
1,035,000 |
210,000 |
25,000 |
|
Ave Profit |
552,000 |
||||
|
ARRG |
11.50% |
|
Profitability Index (PI) |
||||||
|
Rate |
13.8% |
|||||
|
Year |
0 |
1 |
2 |
3 |
4 |
5 |
|
Cash Flows |
– 4,800,000 |
2,080,000 |
1,200,000 |
1,930,000 |
1,105,000 |
1,245,000 |
|
Discount Factor |
1.00000 |
0.87873 |
0.77217 |
0.67854 |
0.59625 |
0.52395 |
|
Present Value |
– 4,800,000 |
1,827,768 |
926,609 |
1,309,575 |
658,860 |
652,316 |
|
NPV |
$575,129 |
|||||
|
PI |
1.12 |
|
NPV |
||||||
|
Net present value of the project is $575129 which means that this project is acceptable because it has positive net present value (NPV). Positive net present value denotes that if solus (an Australian manufacturer) invest the capital on this project then he will be benefited by $575129. Net present value is positive, so it can be concluded that solus (an Australian manufacturer) should invest in this project to earn profit of $575129 (considering time value of money). |
||||||
|
IRR |
||||||
|
Internal rate of return is a rate of return where present value of cash inflows is equal to present value of cash outflows. At 19.14%, present value of cash outflow will be equal to present value of cash inflow. |
||||||
|
Payback Period |
||||||
|
Payback period is a period which defines the length of time required by a company to recover the initial cash outflow. In this case payback period is 2.79 years, which means that Solus (An Australian manufacturer) will recover his initial outlay cost in 2.79 years, at 2.79 years he will recover all his investment in the project. In case this life of project is 5 years, and Solus is able to recover all this initial outlay in 2.79 years, hence this project should be accepted by him. |
||||||
|
ARR |
||||||
|
Accounting rate of return is a rate of return which is also known as average rate of return. It is used as accounting tool in capital budgeting. In present case study accounting rate of return is 11.50%, which means that Solus will generate net income (which will be 11.50% of average investment). Accounting rate of return is positive; hence Solus should accept the project. Accounting rate of return can be calculates as: Average profit/Average investment. |
||||||
|
PI |
||||||
|
Profitability index can be calculated as =present value cash inflow/present value of cash outflow. When profitability index(PI) is 1, then there will be no profit no loss(break-even).In present case profitability index (PI) is 1.12 which is more than 1, it means that present value of cash inflow is 1.12 times of present value of cash outflow. It is favorable; hence Solus should accept the project. |
||||||
|
Conclusion: |
||||||
|
Srl. No. |
Technique |
Decision |
||||
|
1 |
NPV |
$ 575129 |
Accept the project |
|||
|
2 |
IRR |
19.14% |
Accept the project |
|||
|
3 |
Payback Period |
2.79 |
Accept the project |
|||
|
4 |
ARR |
11.50% |
Accept the project |
|||
|
5 |
PI |
1.12 |
Accept the project |
|||
|
After considering all the techniques, we can conclude that project is viable; Solus (An Australian manufacturer should accept the project). |
||||||
|
Treatment of Salvage Value |
||||||
|
In this question, Salvage value is considered in the cash inflows at the end of the 5th year for all the techniques except ARR. In ARR, salvage value is not a part of profit; hence the same is removed while computing the Average Profits. |
||||||
|
Treatment of Loan Repayments |
||||||
|
In this question, Interest Payment along with the Principal considered in the cash outflows at the end of the each year. Equal annual installment was computed using PMT formula which comes to $ 610631. |
|
Debt Rate |
8.6% |
Borrow |
2400000 |
|||
|
(b) |
||||||
|
OB |
Interest |
Repayment |
CB |
|||
|
$2,400,000 |
$206,400 |
$2,606,400 |
$610,631 |
$1,995,769 |
||
|
$1,995,769 |
$171,636 |
$2,167,405 |
$610,631 |
$1,556,774 |
||
|
$1,556,774 |
$133,883 |
$1,690,656 |
$610,631 |
$1,080,025 |
||
|
$1,080,025 |
$92,882 |
$1,172,907 |
$610,631 |
$562,276 |
||
|
$562,276 |
$48,356 |
$610,631 |
$610,631 |
$0 |
||
|
(a) |
Repayments |
$610,631 |
|
NPV |
|
|
Inputs taken from the question |
|
|
Cost of new machine |
$ 12,800,000 |
|
Cost of Capital after tax |
10.65% |
|
Estimated life of machine |
4 |
|
Salvage Value at the end of year four |
$ 960,000 |
|
Diminishing Value Depreciation Rate |
50.00% |
|
Gain on Sale of machine |
$ 160,000 |
|
Book Value at the end year four |
$ 800,000 |
|
Working capital Invested in year zero |
$ 370,000 |
|
Working capital Recovered at the end of year four |
$ 370,000 |
|
Taxation rate |
27% |
|
Annual Marketing and Administration expense |
$ 251,000 |
|
Annual Sales for year one |
$ 24,016,000 |
|
Annual sales growth |
4% |
|
Projected Inflation |
2% |
|
Annual Operating Expenditure 68% of sales |
68% |
|
Investment Allowance |
20% |
|
Computation of taxable income: |
|
|
Particulars |
0 |
|
Revenue |
|
|
Operating Expenditure |
|
|
Gain or Loss on Sale |
|
|
Investment Allowance |
|
|
Depreciation |
|
|
Marketing and Administration |
|
|
Total taxable income |
|
|
Tax @ 27% |
|
|
Computation of Cash inflows and Cash outflows: |
|
|
Particulars |
0 |
|
Revenue |
|
|
Operating Expenditure |
|
|
Salvage Value |
|
|
Marketing and Administration |
|
|
Initial Outlay |
(12,800,000) |
|
Working Capital |
(370,000) |
|
Tax |
|
|
Net Cash flows |
(13,170,000) |
|
PVF @ 10.65% |
1.00000 |
|
Present Value of Cash Flows |
(13,170,000) |
|
NPV |
$ 8,979,300 |
|
Recommendation: Company should invest in the project as Net present value is positive which means that present value of cash inflows exceeds by $ 8979300 from present value of cash outflows. Positive net present value means that we can accept the order. |
|
|
Notes (Workings): – |
|
|
Annual sales |
|
|
Price per unit |
$158 |
|
Units sold per annum |
152,000 |
|
Total Revenue |
$24,016,000 |
|
Cash Operating Expense @ 68% |
$16,330,880 |
|
Feasibility Study – Ignored as the same is sunk cost and same are ignored in decision making analysis. |
$500,000 |
|
Head Office Expense – Ignored as no additional cost incurred due to this project. Only incremental costs considered for decision making analysis. |
$230,000 |
|
Depreciation Schedule |
|
|
Cost of Asset |
$ 12,800,000 |
|
Depreciation Rate |
50.00% |
|
Depn. Amount Yr 1 |
$ 6,400,000 |
|
Written Down Value (WDV) |
$ 6,400,000 |
|
Depreciation Rate |
50.00% |
|
Depn. Amount Yr 2 |
$ 3,200,000 |
|
Written Down Value (WDV) |
$ 3,200,000 |
|
Depreciation Rate |
50.00% |
|
Depn. Amount Yr 3 |
$ 1,600,000 |
|
Written Down Value (WDV) |
$ 1,600,000 |
|
Depreciation Rate |
50.00% |
|
Depn. Amount Yr 4 |
$ 800,000 |
|
Written Down Value (WDV) |
$ 800,000 |
|
Salvage Value |
$ 960,000 |
|
Gain on Sale |
$ 160,000 |
|
Capital Gain(CG) – If salvage value (SV) is higher than the book value(BV) |
|
|
Book Value(BV) – Cost of Asset less accumulated depreciation |
|
(i) |
||||
|
Sensitivity Analysis to Sales Revenue |
||||
|
Particulars |
1 |
2 |
3 |
4 |
|
Sales Revenue |
$ 24,016,000 |
$ 24,976,640 |
$ 25,975,706 |
$ 27,014,734 |
|
PVF @ 10.65% |
0.90375 |
0.81677 |
0.73815 |
0.66711 |
|
Present Value of Sales Revenue |
$ 21,704,474 |
$ 20,400,047 |
$ 19,174,017 |
$ 18,021,669 |
|
Cumulative Present Value of Sales Revenue |
$ 21,704,474 |
$ 42,104,521 |
$ 61,278,538 |
$ 79,300,207 |
|
Hence Sensitivity (%) |
(Present value of Sales Revenue – Present value of sales revenue at which NPV will be zero) |
|||
|
(Present value of Sales Revenue |
||||
|
11.32% |
||||
|
(ii) |
||||
|
Sensitivity Analysis to Cost of Capital |
||||
|
Hence Sensitivity (%) |
Change * 100 |
|||
|
Base |
||||
|
22.54% |
Scenario analysis & sensitivity analysis play a very important role to know the profitability of the project. But scenario analysis provides additional insight which is not provided by sensitivity analysis. Scenario analysis assesses different type of instabilities & the desired routes where it can be performed. Scenario analyses can be defined as a process to assess the future outcome whereas sensitivity is the uncertainty in outcome in terms of mathematics. It is used to examine how independent variable impacts the dependent variable. Scenario analysis considers the uncertainty in all aspect which is not considered by sensitivity analysis.
Risk has been priced in this project is due to inflation, sales and marketing expenses will increase due to inflation. But management of Multimaxx steel division is confident that return on investment is in accordance with risk because additional annual sales will overcome the effect of increases in costs due to inflation.
References:
Sheffrin (2003), Economics: Principles in Action, Upper Saddle River, New Jersey: Pearson Prentice,395-400.
K.L. Maheshwari (2001), Managerial Economics, India: Sultan Chand & Sons, 885-997.
Anonymous (2005), International Good Practice: Guidance on Project Appraisal Using Discounted Cash Flow, India.
Joseph Tham (2008), Prospective Analysis: Guidelines for Forecasting Financial Statements, London.
Ignacio Velez-Pareja( 2008),To Plug or Not to Plug, that is the Question: No Plugs, No Circularity: A Better Way to Forecast Financial Statements, PI hall, United kingdom.
Ignacio Velez-Pareja (2008),A Step by Step Guide to Construct a Financial Model Without Plugs and Without Circularity for Valuation Purposes, PI hall, United kingdom
Sergei Cheremushkin (2008), Long-Term Financial Statements Forecasting: Reinvesting Retained Earnings, London.
Shveta Singh(2002), Introduction to capital budgeting, Department of Management Studies, Indian Institute of Technology, India
P.K. Jain (2005),Net present value calculation, Department of Management Studies, Indian Institute of Technology Delhi, India
Surendra S. Yadav (2009), Techniques in capital budgeting, Department of Management Studies, India.
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