Question

hanex limited is considering investing $50,000/- in a new machine with an expected life life of 5 years. the machine will have no scrap value at the end of five years.it is expected that 2000 units will be sold each year at a selling price of $3.00 per unit, variables production cots are expected to be $1.65 per unit, while incremental fixed cost, mainly the wages of maintenance engineer are expected to be $10.000/- per year. Hanex limited uses a discount rate of 12% for investment appraisal purposes and expects investment projects to recover their initial investment within two years.

required

a. calculate and comment on the payback period of the project

b. calculate and comment on the net present value of the project

c. identify the limitations of the net present value techniques when applied generally to investment appraisal

d. explain why risk an uncertainty should be considered in the investment appraisal

Answer 1

ANSWER;

(A)CALCULATE THE PAT BACK PERIOD:

	UNITS	SALE PRICE	VARIABLE COST	GROSS PROFIT	TOTAL GROSS	FIXED COST	NET CASH FLOW
1 TO 5	20000	3	1.65	1.35	27000	10000	17000

The payback period in case of uniform cash flows being produced is calculated by dividing initial investment by the annual net cash inflow. In the given case it is 50,000 divided by 17,000 that results in 2.94 years as the payback period. The payback period is 2.94 years which means that it will take 2.94 years to realize the initial investment. The life of the asset is 5 years and the payback period is less than the life which means this is a wise investment to be made.

(B)CALCULATE NET PRESENT VALUE

Net cash inflow	Annuity @ 12%	Present value
17000	3.6058	61298.6

The net present value is the present value minus the initial investment which is 61,298.6 minus 50,000 which is equal to 11,298.6.A positive net present value always means that the investment would be a profitable one and worth investing.

(C) The major disadvantage in NPV calculation lies in the very fact that the cost of capital or the discount rate used to calculate the present value is an estimate. It is the result of guesswork. Sometimes a low discount rate could result in choosing some sub-optimal investments and a higher than necessary discount rate could lead to letting go off some otherwise worthy investments.

(D) Very may factors add to the risks and uncertainties associated with an investment. The lengthy a project, the risky it gets about the realization of cash flows and revenues. The size of the investment, if substantial means i is more risky. The economic and the market environment poses more risks due to uncertain demand and changing prices. So, one has to choose an investment considering the fact that the investment has to earn enough to compensate for the risk taken.