Question

tax 30%

This assessment aims to test your knowledge about evaluating projects using capital budgeting methods. Capital budgeting techniques are used widely in the industry. Therefore an understanding of capital budgeting methods is a practical skill which would benefit you in the future as well. Question ABC Limited is considering to introduce a new product to the market. Owing to the fad nature of the product, the project will then be terminated after five years.

The following information is available: Sales price $320 per unit in years 1-4, $200 in year 5 Variable costs $140/unit Annual fixed costs $400,000 Working capital There will be an initial working capital of $100,000 to get production started. For each year, the total investment in net working capital will be equal to 10% of the dollar value of sales for that year. Thus the investment in working capital will increase during years 1 to 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5 Depreciation Straight-line method over five years. It is assumed that the plant and equipment will have no salvage value after five years. Cost of new equipment $8,000,000 Shipping costs $200,000 Projected sales in units Year 1: 180,000 Year 2: 200,000 Year 3: 230,000 Year 4: 130,000 Year 5: 130,000 Cost of capital 6% p.a 2 Based on the data provided above, answer the following questions:

(i) Calculate the relevant cash flows over the next five years associated with the proposed investment.

(ii) Compute the project’s net present value and explain what it signifies.

(iii) Compute the project’s internal rate of return and explain what it signifies.

(iv) Why does capital budgeting rely on analysis of cash flows rather than on net income?

(v) Should ABC invest in this new product investment? Why or why not?

(vi) How widespread is the use of capital budgeting techniques in Australia?

Answer 1

i). Please note that the tax rate is not given in the question so the corporate tax rate of 30% has been taken, as applicable in Australia.

Formula	Year (n)	0	1	2	3	4	5
(Cost of new equipment ++ shipping cost)	Initial investment (I)	-82,00,000
I/5 per year	Depreciation (D)		16,40,000	16,40,000	16,40,000	16,40,000	16,40,000
	Unit sales (U)		1,80,000	2,00,000	2,30,000	1,30,000	1,30,000
	Sales price/unit (p)		320	320	320	320	200
	Variable cost/unit ('vc)		140	140	140	140	140
(U*p)	Total revenue ('R)		5,76,00,000	6,40,00,000	7,36,00,000	4,16,00,000	2,60,00,000
(U*vc)	Total variable cost (VC)		2,52,00,000	2,80,00,000	3,22,00,000	1,82,00,000	1,82,00,000
	Fixed costs (FC)		4,00,000	4,00,000	4,00,000	4,00,000	4,00,000
	Depreciation (D)		16,40,000	16,40,000	16,40,000	16,40,000	16,40,000
(R-VC-FC-D)	EBIT		3,03,60,000	3,39,60,000	3,93,60,000	2,13,60,000	57,60,000
(30%*EBIT)	Tax @30%		91,08,000	1,01,88,000	1,18,08,000	64,08,000	17,28,000
(EBIT-Tax)	Net income		2,12,52,000	2,37,72,000	2,75,52,000	1,49,52,000	40,32,000
	Add: Depreciation (D)		16,40,000	16,40,000	16,40,000	16,40,000	16,40,000
(NI + D)	Operating Cash Flow (OCF)		2,28,92,000	2,54,12,000	2,91,92,000	1,65,92,000	56,72,000

Working capital calculation:

Formula	Year (n)	0	1	2	3	4	5
	Total revenue ('R)		5,76,00,000	6,40,00,000	7,36,00,000	4,16,00,000	2,60,00,000
Year 0: 100,000 & remaining (10%*R)	NWC	1,00,000	57,60,000	64,00,000	73,60,000	41,60,000	26,00,000
(NWC in Year(n-1) - NWC in Year(n))	Change in NWC	-1,00,000	-56,60,000	-6,40,000	-9,60,000	32,00,000	15,60,000

ii). Total cash flows with NPV computation:

Formula	Year (n)	0	1	2	3	4	5
	OCF	-82,00,000	2,28,92,000	2,54,12,000	2,91,92,000	1,65,92,000	56,72,000
	Change in NWC	-1,00,000	-56,60,000	-6,40,000	-9,60,000	32,00,000	15,60,000
(OCF+Change in NWC)	Total cash flow (CF)	-83,00,000	1,72,32,000	2,47,72,000	2,82,32,000	1,97,92,000	72,32,000
(1/(1+d)^n)	Discount rate @6%	1.000	0.943	0.890	0.840	0.792	0.747
(CF*Discount factor)	PV of CF	-83,00,000	1,62,56,604	2,20,46,992	2,37,04,132	1,56,77,118	54,04,171
Sum of all PVs	NPV	7,47,89,016

iii). IRR using the IRR() function in excel with the CF computed above is 234%. (Note: If MIRR is calculated using the given WACC of 6% then MIRR will be 68%)

iv). Net income includes interest expense which is not a factor when deciding on a capital investment. Only operational factors are to be taken into consideration so operating cash flow plus additional expenses in NWC and capex are used.

v). The investment should be made because the NPV is positive.

vi). NPV and IRR are commonly used for capital investment decisions in Australia although payback period is still used as a criteria.