Question

Capital Budgeting Case This case is about the purchase of long-term operational assets which called capital investments. Investment in capital assets normally can be covered only by using those assets Once a company purchases a capital asset, it is committed to that investment for an extended period of time. Business profitability ultimately hinges, to a large extent, on the quality of a few key capital investment decisions. A capital investment decision is essentially a decision to exchange current cash outflows for the expectation of receiving future cash inflows. Managers can choose from numerous analytical techniques to help them make capital investment decisions. Each technique has advantages and disadvantages. This case deals with the concept of time value of money, and using the net present value technique. Steps: 1-Determine the initial investment (cost of the new project, initial cash outflows...etc) 2-Determine the annual net cash inflows 3-Calculate the present value of each cash flow, using appropriate discount rate 4-Calculate the net present value 5-Make the decision 2 The manager of Abu Dhabi Inc. is thinking of combining a new robot system with the current automated system. The following data related to the new system: 1-The cost of purchasing and installing the new system amount of $12,000,000 2-The system requires keeping a working capital (inventories of spare parts) $500,000 3-The cost of the system will be obtained through a 6-year 5% loan from Abu Dhabi National Bank. The loan and its interest will be paid in 6 annual installments 4-The useful life of the new system is 20 years and will be sold then for $300,000 5-The annual sales from operating the new system is expected to be 10,000 units in the first 10 years and 35,000 units in the last 10 years. The selling price is constant at $300 per unit. 6-Cost of goods sold is constant at $200 per unit 7-Annual operating expenses related to the new system 9 $250,000 $100,000 $585,000 $50,000 Selling expenses Administrative expenses Depreciation expenses Other expenses If required rate of return is 89% and NPV model is used, should this project be accepted? Why?

Answer 1

1	Cost of New System	$    12,000,000.00
	Working Capital requirement	$          500,000.00
Less:	Less: Amt financed by Bank	$ (12,000,000.00)
	Net Initial Investment	$          500,000.00

2	Year	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15	16	17	18	19	20
1	Unit Sold	10000	10000	10000	10000	10000	10000	10000	10000	10000	10000	35000	35000	35000	35000	35000	35000	35000	35000	35000	35000
2	Sales per unit	$                  300.00	$                300.00	$                300.00	$                300.00	$                300.00	$                300.00	$                300.00	$              300.00	$              300.00	$              300.00	$              300.00	$              300.00	$              300.00	$              300.00	$              300.00	$              300.00	$              300.00	$              300.00	$              300.00	$              300.00
3	Less: Cost of Goods Sold per unit	$                  200.00	$                200.00	$                200.00	$                200.00	$                200.00	$                200.00	$                200.00	$              200.00	$              200.00	$              200.00	$              200.00	$              200.00	$              200.00	$              200.00	$              200.00	$              200.00	$              200.00	$              200.00	$              200.00	$              200.00
4	Contribution per unit	$                  100.00	$                100.00	$                100.00	$                100.00	$                100.00	$                100.00	$                100.00	$              100.00	$              100.00	$              100.00	$              100.00	$              100.00	$              100.00	$              100.00	$              100.00	$              100.00	$              100.00	$              100.00	$              100.00	$              100.00
5	Total Contribution (1*4)	$      1,000,000.00	$    1,000,000.00	$    1,000,000.00	$    1,000,000.00	$    1,000,000.00	$    1,000,000.00	$    1,000,000.00	$ 1,000,000.00	$ 1,000,000.00	$ 1,000,000.00	$ 3,500,000.00	$ 3,500,000.00	$ 3,500,000.00	$ 3,500,000.00	$ 3,500,000.00	$ 3,500,000.00	$ 3,500,000.00	$ 3,500,000.00	$ 3,500,000.00	$ 3,500,000.00
6	Less: Installment repayment	$          (2,364,210)	$       (2,364,210)	$       (2,364,210)	$       (2,364,210)	$       (2,364,210)	$       (2,364,210)
7	Less:   Selling Cost	$       (250,000.00)	$     (250,000.00)	$     (250,000.00)	$     (250,000.00)	$     (250,000.00)	$     (250,000.00)	$     (250,000.00)	$   (250,000.00)	$   (250,000.00)	$   (250,000.00)	$   (250,000.00)	$   (250,000.00)	$   (250,000.00)	$   (250,000.00)	$   (250,000.00)	$   (250,000.00)	$   (250,000.00)	$   (250,000.00)	$   (250,000.00)	$   (250,000.00)
8	Less:   Admin Cost	$       (100,000.00)	$     (100,000.00)	$     (100,000.00)	$     (100,000.00)	$     (100,000.00)	$     (100,000.00)	$     (100,000.00)	$   (100,000.00)	$   (100,000.00)	$   (100,000.00)	$   (100,000.00)	$   (100,000.00)	$   (100,000.00)	$   (100,000.00)	$   (100,000.00)	$   (100,000.00)	$   (100,000.00)	$   (100,000.00)	$   (100,000.00)	$   (100,000.00)
9	Less: Other Expenses	$          (50,000.00)	$       (50,000.00)	$       (50,000.00)	$       (50,000.00)	$       (50,000.00)	$       (50,000.00)	$       (50,000.00)	$      (50,000.00)	$      (50,000.00)	$      (50,000.00)	$      (50,000.00)	$      (50,000.00)	$      (50,000.00)	$      (50,000.00)	$      (50,000.00)	$      (50,000.00)	$      (50,000.00)	$      (50,000.00)	$      (50,000.00)	$      (50,000.00)
10	Working Capital repaid																				$      500,000.00
11	Salvage Value of the system																				$      300,000.00
	Annual Net Cash Inflows	$    (1,764,209.62)	$ (1,764,209.62)	$ (1,764,209.62)	$ (1,764,209.62)	$ (1,764,209.62)	$ (1,764,209.62)	$       600,000.00	$      600,000.00	$      600,000.00	$      600,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,900,000.00

3	Year	Total	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15	16	17	18	19	20
	Annual Net Cash Inflows	$    23,614,742.30	$ (1,764,209.62)	$ (1,764,209.62)	$ (1,764,209.62)	$ (1,764,209.62)	$ (1,764,209.62)	$ (1,764,209.62)	$      600,000.00	$      600,000.00	$      600,000.00	$      600,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,100,000.00	$ 3,900,000.00
	Disc Factor @ 8%		0.9259	0.8573	0.7938	0.7350	0.6806	0.6302	0.5835	0.5403	0.5002	0.4632	0.4289	0.3971	0.3677	0.3405	0.3152	0.2919	0.2703	0.2502	0.2317	0.2145
	Present Value of the Cash Flows	$      2,903,235.47	$ (1,633,527.42)	$ (1,512,525.39)	$ (1,400,486.47)	$ (1,296,746.74)	$ (1,200,691.42)	$ (1,111,751.32)	$      350,094.24	$      324,161.33	$      300,149.38	$      277,916.09	$ 1,329,536.86	$ 1,231,052.65	$ 1,139,863.57	$ 1,055,429.23	$      977,249.29	$      904,860.45	$      837,833.75	$      775,771.99	$      718,307.40	$      836,738.01

4	Present Value of the Cash Flows	$      2,903,235.47
	Less: Initial Cash Outflows	$       (500,000.00)
	Net Present Value	$      2,403,235.47

5	Decision:- Since the NPV is possitive (+ve), so the management should accept the decision.