The research and development department of SAMARINA SA has produced two designs
ID: 2716086 • 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
Discount rate 12% Year 0 1 2 3 4 5 Development cost -100000 Machinery -3000000 CF 420000 420000 1000000 2400000 1200000 Salvage value 80000 PV@12% -3100000 375000 334821.4 711780.2 1525243 726306.4 NPV 573151.4399 IRR 5.00% Average accounting income 734630.288 Accounting rate of return 23.70% Depretiation is not considered Payback period 2.416726082 Years Discount rate 12% Year 0 1 2 3 4 5 Development cost -120000 Machinery -2200000 CF 800000 1000000 450000 450000 450000 Salvage value 150000 PV@12% -2320000 714285.7 797193.9 320301.1 285983.1 340456.1 NPV 138219.9521 IRR 2.37% Average accounting income 491643.9904 Accounting rate of return 21.19% Depretiation is not considered Payback period 2.480524158 Years Model 1 is better than model 2 as its NPV,IRR are higher for model 1.And discounted payback is less for model 1 indicating initial investments will be recovered early Further information on opperating models of both the models,and repair and maintainance costs,depretiaion methods,tax poilicies will give clearer picture.