Question

Question 2 The R.M. Company uses the following risk-adjusted discount rates for capital budgeting purposes: Investments in new product lines 16% Substitution of labour with capital (machinery) 10% Expansion of existing product lines 12% Replacement of existing equipment 8% The firm has $500,000 of available capital for investment. Project A involves the production of a brand new product line. Project B involves the replacement of existing machinery. Project C involves the purchase of a more sophisticated piece of equipment as a replacement for existing machinery. This more sophisticated machine will enable R.M. Company to reduce the size of its workforce. There are no other projects available at this time. Expected cash flows for these independent projects are as follows: Projects A (in thousands of dollars) - 400 - 500 - 100 Investment (t=0) Net after-tax cash inflows (t=1) (t=2) (t=3) (t=4) 160 130 150 150 140 180 130 210 Which project(s) would you recommend the company undertake? Show your calculations and provide any necessary explanations. (4 marks)

Answer 1

For project A, the applicable discount rate is of 16%

For project A, the applicable discount rate is of 8%

For project A, the applicable discount rate is an average of 8% and 9% because it is both a replacement of equipment as well as substitution of labor with capital

To figure out which projects should be taken, we need to calculate the Net Present Value (NPV) of each project as shown below:

А Cash flows PV factor (=1/(1+discount rate)nt) PV of cash flows Cash flows PV factor (=1/(1+discount rate)at) PV of cash flows Cash flows PV factor (=1/(1+discount rate)^t) PV of cash flows -400 -400 -500 1 -500 -100 -100 investment (t=0) Net after-tax cash inflows 1 160 150 140 0.8621 0.7432 0.6407 0.5523 137.93 111.47 89.69 71.80 10.90 0.9259 0.8573 0.7938 0.7350 120.37 128.60 142.89 154.36 46.22 0.9174 0.8417 0.7722 0.7084 180 27.52 33.67 38.61 42.51 42.30 130 210 Net Present values

As we see, the NPVs of project B & C are considerably higher than project A. Higher NPV implies that these projects are likely to add more value to the firm (and thus to shareholders' weatlh). So the company may take Project B & C. Between these two, Project B should be preferred as it offers higher NPV.