The research and development department of SAMARINA SA has produced two designs
ID: 2715560 • Letter: T
Question
The research and development department of SAMARINA SA has produced two designs of product XYZ: model One and model Two. The development costs incurred, and already paid; in getting the models to design stage are €100,000 for model One and €120,000 for model Two. However, management has decided that the company has the facilities to support production and sales of only one of the two models in the foreseeable future.
For model One, it requires an investment in machinery with an estimated useful life of five years. The machinery will cost €3,000,000 and possess a disposal value of €200,000 if resold during the first three years of ownership, and €80,000 thereafter.
For model Two, the machinery would cost €2,200,000, have a useful economic life of five years and a disposable value of €150,000 at any time after initial installation.
The marketing department has estimated the annual demand for each model for the five years commencing 1 January 2013, which is the expected time period over which either model would be sold. The financial planning department has produced the following estimated annual operating cash flows:
Model One
€000
Model Two
€000
2013
420
800
2014
420
1,000
2015
1,000
450
2016
2,400
450
2017
1,200
450
It may be assumed that the annual operating cash flows will arise on the 31 of December in each year.
The company’s money cost of capital is 12%.
You are required to:
(a) Calculate the following values for the investment proposals and discuss your findings of whether it is financially acceptable.
(i) net present value;
(ii) internal rate of return;
(iii) return on capital employed (accounting rate of return) based on average investment;
(iv) discounted payback period.
(b) Critically evaluate the use of NPV approach in proposed investments.
(c) Discuss what further information might be obtained to assist a fuller analysis.
Model One
€000
Model Two
€000
2013
420
800
2014
420
1,000
2015
1,000
450
2016
2,400
450
2017
1,200
450
Explanation / Answer
Critical Evaluation of NPV approach:
Model 1 Useful life in years 5 Cost $ 3000000 Salvage $ first 3 years 200000 Therafter 80000 Cum Cash PV 12% flows PVIF-12% PV SV PVIF 20% PV 20% PVIF 18% PV 18% Year 1 420000 0.893 375000 200000 0.833333 350000 0.847458 355932 375000 2 420000 0.797 334821 200000 0.694444 291667 0.718184 301637 709821 3 1000000 0.712 711780 200000 0.578704 578704 0.608631 608631 1421602 4 2400000 0.636 1525243 80000 0.482253 1157407 0.515789 1237893 2946845 5 1200000 0.567 680912 80000 0.401878 482253 0.437109 524531 3627757 Total PV of Operating CFs 5440000 3627757 Add: PV of SV 80000 0.567 45360 0.401878 32150 0.437109 34969 PV of Cash flows 3673117 2892181 3063594 Original Cost 3000000 NPV 673117 IRR Interpolating between 20% and 18% = 18+[63594/(3063594-2892181)]*2 = 18.74 ARR [(5440000/5)/(3000000+80000)/2]*100 70.64935 Discounted Payback 4 Years + (3000000-2946845)/680912 = 4.08 Years Model 2 Useful life in years 5 Cost $ 2200000 Salvage $ first 3 years Therafter Any time Cash 150000 flows PVIF-12% PV SV PVIF 18% PV 18% PVIF 16% PV 16% PV 12% Cum Year 1 800000 0.893 714286 150000 0.847458 677966.1 0.862069 689655.2 714286 714286 2 1000000 0.797 797194 150000 0.718184 718184.4 0.743163 743162.9 797194 1511480 3 450000 0.712 320301 150000 0.608631 273883.9 0.640658 288296 320301 1831781 4 450000 0.636 285983 150000 0.515789 232105 0.552291 248531 285983 2117764 5 450000 0.567 255342 150000 0.437109 196699.1 0.476113 214250.9 255342 2373106 Total PV of Operating CFs 3150000 2373106 Add: PV of 150000 0.567 85050 0.437109 65566.38 0.476113 71416.95 PV of Cash flows 2458156 2164405 2255313 Original Cost 2200000 NPV 258156 IRR Interpolating between 18% and 16% = 16+[55313/(2255313-2164405)]*2 = 17.22 ARR (630000/1175000)*100 53.62 Discounted PAYBACK 4+82236/255342= 4.32 Years or 4 Years & 3 Months