Newlands Brewery is evaluating a new product line for the production of two new
ID: 2614724 • Letter: N
Question
Newlands Brewery is evaluating a new product line for the production of two new cider brands for the young affluent target market. The brewery is currently operating at its optimal capacity and it will have to invest in an expansion for new machinery and production space. The expected cash flows for the two cider brands are:
Project Cider A, Cashflows are as follows , Year 0=(25 000), Year 1=12 900, Year 2=10 900, Year 3 =8 300 and year 4=7 240.
Project Cider B, Cashflows are as follows , Year 0=(13 500), Year 1=7 230, Year 2=8 200, Year 3 =8 600 and year 4=5 400
Also the expected net income figures for the new product line are as follows
Project Cider A net incomes Year 1=6 728, Year 2=4 800, Year 3 =2 009 and Year 4= 7 420
Project Cider B net incomes Year 1=3 855, Year 2=4 725, Year 3=5 255 and Year 4 =1 864
Consider the following information:
• The average book value for Cider A project is R12,500,000
• The average book value for Cider B project is R6,800,000
• Management requires 15 percent for the project to go ahead based on accounting rate of return perspective
• The discount rate for a project of similar risk level is 10 percent
• Management requires a minimum payback of 1.75 years for the type of risk associated with this project
Required:
Taking into consideration that the two projects are independent and no scaling issues, what should Newlands Brewery do? Your answer should be supported by the analysis of the following calculations:
• Payback method
• Discounted payback method
• Accounting rate of return (using averages)
• Net present value
• Internal rate of return
• Profitability index
Now consider the presence of scaling issue, which project should Newland Brewery consider?
Explanation / Answer
project cider A project cider B Year 0 -25000 -13500 Year 1 12,900.00 7,230.00 Year 2 10900 8200 Year 3 8300 8600 Year 4 7240 5400 Total cash flows 14340 15930 (A ) Payback period ( in years ) 1.74 0.85 For project cider A PV @ 10 % Year 0 -25000 -25000 Year 1 12900 11,727.27 -13,272.73 Year 2 10900 9,008.26 -4,264.46 Year 3 8300 6,235.91 1,971.45 Year 4 7240 4,945.02 6,916.47 Discounted Payback Period formula = Year before the discounted payback period occurs + (Cumulative cash flow in year before recovery / Discounted cash flow in year after recovery) (B ) Discounted payback = 2 + .38 2.38 :=2+ 4246/11180 For project cider B PV @ 10 % Year 0 -13500 -13500 Year 1 7,230.00 6,572.73 -6,927.27 Year 2 8200 6,776.86 -150.41 Year 3 8600 6,461.31 6,310.89 Year 4 5400 3,688.27 9,999.17 Discounted Payback Period formula = Year before the discounted payback period occurs + (Cumulative cash flow in year before recovery / Discounted cash flow in year after recovery) Discounted payback = 2+.01 2.01 :=2+ 150/10150 (C ) Accounting rate of return Project cider A Project cider B Year 1 6278 3855 Year 2 4800 4725 Year 3 2009 5255 Year 4 7420 1864 TOTAL net incomes 20507 15699 Avg net income 5126.75 3924.75 Investment 25000 13500 ARR 20.51 29.07 (D) NET PRESENT VALUE NPV Project cider A Cash flows PV @ 10 % 10% Year 0 -25000 Year 1 12900 11,727.27 Year 2 10900 9,008.26 Year 3 8300 6,235.91 Year 4 7240 4,945.02 PV OF all cash flows 31,916.47 NPV ( pv - initial investment 6,916.47 NPV Project cider b Cash flows PV @ 10 % Year 0 -13500 Year 1 7,230.00 6,572.73 Year 2 8200 6,776.86 Year 3 8600 6,461.31 Year 4 5400 3,688.27 PV OF all cash flows 23,499.17 NPV ( pv - initial investment 9,999.17 (D) Internal rate of return NPV Project cider A Cash flows PV @ 23.77 % Year 0 -25000 Year 1 12900 10,422.56 Year 2 10900 7,115.34 Year 3 8300 4,377.56 Year 4 7240 3,085.16 PV OF all cash flows 25,000.61 rate at which the NPV is zero IRR 23.77% NPV Project cider b Cash flows PV @ 41.95 % Year 0 -13500 Year 1 7,230.00 5,093.34 Year 2 8200 4,069.52 Year 3 8600 3,006.71 Year 4 5400 1,330.00 PV OF all cash flows 13,499.58 rate at which the NPV is zero IRR 41.95%