Solution to Question Five
a. Calculation of values for the investment proposal
The evaluation is based on incremental cash flows from the investment. Without the
investment, production is capped at 5,000 units per year (or demand if lower), sold
at $50 per unit with variable costs of $28 per unit. With the investment, capacity
increases to 10,000 units per year, but the selling price drops to $45 per unit for all
units sold, with additional fixed operating costs of $15,000 per year. No taxation is
considered, and the product life is 4 years with no terminal or scrap value.
Units produced/sold:
Without investment: 5,000 (Year 1), 5,000 (Year 2), 5,000 (Year 3), 4,000 (Year
4).
With investment: 7,000 (Year 1), 9,000 (Year 2), 10,000 (Year 3), 4,000 (Year
4).
Incremental cash flows (operating, before depreciation):
Year 1: ($45 × 7,000 - $28 × 7,000) - ($50 × 5,000 - $28 × 5,000) - $15,000
= -$6,000.
Year 2: ($45 × 9,000 - $28 × 9,000) - ($50 × 5,000 - $28 × 5,000) - $15,000
= $28,000.
Year 3: ($45 × 10,000 - $28 × 10,000) - ($50 × 5,000 - $28 × 5,000) -
$15,000 = $45,000.
Year 4: ($45 × 4,000 - $28 × 4,000) - ($50 × 4,000 - $28 × 4,000) - $15,000
= -$35,000.
Initial investment: -$20,000 at time 0.
i. Net present value
To calculate NPV, discount the incremental cash flows at the nominal rate of 10%:
NPV = -$20,000 + (-$6,000 / 1.10¹) + ($28,000 / 1.10²) + ($45,000 / 1.10³) + (-
$35,000 / 1.10⁴).
Step-by-step:
PV of Year 1: -$6,000 / 1.10 = -$5,454.55.
PV of Year 2: $28,000 / 1.21 = $23,140.50.
PV of Year 3: $45,000 / 1.331 = $33,809.92.
PV of Year 4: -$35,000 / 1.4641 = -$23,906.22.
Sum of PVs = -$20,000 - $5,454.55 + $23,140.50 + $33,809.92 - $23,906.22
= $7,590 (rounded).
ii. Internal rate of return
IRR is the discount rate where NPV = 0. Solve for r in:
-$20,000 + (-$6,000 / (1 + r)¹) + ($28,000 / (1 + r)²) + ($45,000 / (1 + r)³) + (-
$35,000 / (1 + r)⁴) = 0.
Using numerical methods (e.g., root-finding algorithm), the solution is r ≈ 30.6%. To
arrive at this, test rates iteratively: NPV > 0 at 30% ($181) and NPV < 0 at 31% (-
$135), refining between these bounds converges to 30.6%. Note: The cash flow
signs change twice, potentially indicating multiple IRRs, but the relevant positive
rate is 30.6%.
iii. Return on capital employed (accounting rate of return) based on initial
investment
ARR = (Average annual accounting profit / Initial investment) × 100%.
Depreciation on new machine: $20,000 / 4 years = $5,000 per year (straight-line).
Incremental accounting profits (incremental cash flows minus depreciation):
Year 1: -$6,000 - $5,000 = -$11,000.
Year 2: $28,000 - $5,000 = $23,000.
Year 3: $45,000 - $5,000 = $40,000.
Year 4: -$35,000 - $5,000 = -$40,000.
Average profit = (-$11,000 + $23,000 + $40,000 - $40,000) / 4 = $3,000.
ARR = ($3,000 / $20,000) × 100% = 15%.
iv. Discounted payback period
Cumulative discounted cash flows:
End of Year 0: -$20,000.
End of Year 1: -$20,000 - $5,454.55 = -$25,454.55.
End of Year 2: -$25,454.55 + $23,140.50 = -$2,314.05.
End of Year 3: -$2,314.05 + $33,809.92 = $31,495.87.
End of Year 4: $31,495.87 - $23,906.22 = $7,589.65.
The cumulative becomes positive during Year 3. Interpolate: After Year 2, -
$2,314 remains to recover; Year 3 PV = $33,810. Fraction = $2,314 / $33,810
≈ 0.068.
DPP = 2 + 0.068 = 2.07 years.
b. Discussion of findings and advice on financial acceptability
In (i), the NPV is positive at $7,590 using the 10% discount rate, indicating the
investment adds value and exceeds the cost of capital. This supports acceptance,
as NPV > 0 is a key criterion for profitability.
In (ii), the IRR of 30.6% far exceeds the 10% cost of capital, reinforcing
acceptability. However, the non-conventional cash flows (with a negative flow in
Year 4) could imply multiple IRRs, though the primary rate is robustly above the
hurdle. IRR's reinvestment assumption at the IRR rate may overestimate benefits
compared to NPV's more conservative approach.
In (iii), the ARR of 15% falls short of the 20% target ROCE, suggesting the
investment does not meet the company's accounting return expectations. ARR is
simple but ignores cash flow timing and uses accounting profits (including non-cash
depreciation), making it less reliable than NPV or IRR for decision-making.
In (iv), the DPP of 2.07 years is short relative to the 4-year project life, indicating
quick recovery of the investment in present value terms. This is favorable for
liquidity and risk, especially with uncertain demand in later years, though no explicit
payback target is given.
Overall, the investment is financially acceptable. NPV and IRR strongly support it,
outweighing the ARR shortfall, as these methods better account for time value and
cash flows. The positive NPV confirms value creation, and the short DPP mitigates
risk. Proceed with the investment, but monitor market demand and price sensitivity.
c. Key steps in a company's capital budgeting process
1. Project identification and screening: Identify potential investments
through strategic planning, market analysis, or internal suggestions, and
screen them against basic criteria like alignment with company goals.
2. Estimation of cash flows and parameters: Forecast incremental cash
inflows/outflows, project life, initial costs, and relevant rates (e.g., discount
rate), incorporating assumptions on sales, costs, and risks.
3. Evaluation and analysis: Apply appraisal techniques such as NPV, IRR, ARR,
and payback period to assess viability; conduct sensitivity, scenario, or risk
analysis to test assumptions.
4. Decision-making and approval: Compare results against benchmarks (e.g.,
NPV > 0, IRR > cost of capital), rank projects if capital is limited, and obtain
management approval.
5. Implementation and monitoring: Allocate resources, execute the project,
and track performance against forecasts.
6. Post-audit review: After completion, evaluate actual vs. projected outcomes
to improve future processes and accountability.