Question

Q3 ( Capital budgeting methods) {25 Marks) Yummy Candy Company is considering purchasing a second chocolate dipping machine in order to expand their business. The information Yummy has accumulated regarding the new machine is: Cost of the machine $80,000 $15,000 Increased annual contribution margin Life of the machine 10 years Required rate of return 6% Yummy estimates they will be able to produce more candy using the second machine and thus increase their annual contribution margin. They also estimate there will be a small disposal value of the machine but the cost of removal will offset that value. Ignore income tax issues in your answers. Assume all cash flows occur at year-end except for initial investment amounts. Required: 1.Calculate the following for the new machine: a.Net present value b.Payback period cinternal rate of return (using the interpolation method) 2.What other factors should Yummy Candy consider in deciding whether to purchase the new machine? 3. What concept must be considered when looking at cash flows over several years for a long- term investment. Explain

Answer 1

1 a) Net present value Annual cash inflows Present value factor of 6% for 10 yea Present value of cash inflows Less: Initial investment Net present value $15,000 7.36009 $110,401 $80,000 $30,401 Years b) Payback period Initial investment Annual cash inflows $80,000 $15,000 5.33 b) Internal rate of return Annual cash inflows Present value factor for 10 years Present value of cash inflows Less: Initial investment Net present value Discount factor 12% 14% $15,000 $15,000 5.65022) 5.2161156 $84,753 $78,242 $80,000 $80,000 $4,753 $1,758 Internal rate of return = 12 % +($4,753/($4,753-(-$1,753))*(14%-12%) Internal rate of return = 12% + 1.46% = 13.46% 2 Other factors to be considered Reliability of machine Reputation of the Vendor Quality of output of machine Impact on the morale of employees Technical support availability Impact of technology on the machine 3 Time value of money should be considered while looking at cash flows for each year As per this concept the value of money today is more than what will be received in future years The cash flow received over a period of time is not same value since it is received at different point of time. Hence NPV and IRR analysis play an important role in evaluation of capital budgets 4 Weakness of cash payback approach It does not consider time value of money It ignores the cash flows after investment recovery It is complicated to apply when there are multiple investments over a period of time It ignores inflation factors It ignores cost of capital required to fund the project