The research and development department of SAMARINA SA has produced two designs
ID: 2716573 • 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
Results may vary with your given answer based on discouting factor used. I have taken 4 digit factor for better accuracy Initial design costs ignored as those are sunk cost without any effect on cash flows Assuming opearting cash flows given does not include machine salvage value Model One IRR Operating Cash flow Investment Total Cash Flow Discount factor @12% PV Of cash Flows Depreciation Accounting return Operating Cash flow Discount factor @18.7% PV Of cash Flows Initial Investment (3,000) (3,000) 1 (3,000) Initial Investment -3000 1 (3,000) 2013 420 420 0.8929 375 584 (164) 2013 420 0.8425 354 2014 420 420 0.7972 335 584 (164) 2014 420 0.7097 298 2015 1,000 1,000 0.7118 712 584 416 2015 1,000 0.5979 598 2016 2,400 2,400 0.6355 1,525 584 1,816 2016 2,400 0.5037 1,209 2017 1,200 80 1,280 0.5674 726 584 616 2017 1,280 0.4244 543 NPV $ 673.15 673 2,520 2 IRR 18.70% Average accounting return /year 504.0 Average Investment 1,540.0 Accounting rate of return 32.73% Discounted Payback 4.073 years Details Amt '000 Asset Cost 3,000 Disposal value 80 Average Investment 1,540 Depreciable Value 2,920 Useful Life years 5 Deprecation per year(SL Method) 584 Assuming opearting cash flows given does not include machine salvage value Model Two IRR Operating Cash flow Investment Total Cash Flow Discount factor @12% PV Of cash Flows Depreciation Accounting return Operating Cash flow Discount factor @17.24% PV Of cash Flows Initial Investment (2,200) (2,200) 1 (2,200) Initial Investment -2200 1 (2,200) 2013 800 800 0.8929 714 410 390 2013 800 0.8530 682 2014 1,000 1,000 0.7972 797 410 590 2014 1,000 0.7275 728 2015 450 450 0.7118 320 410 40 2015 450 0.6205 279 2016 450 450 0.6355 286 410 40 2016 450 0.5293 238 2017 450 150 600 0.5674 340 410 40 2017 600 0.4515 271 NPV $ 258.22 258 1,100 (2) IRR 17.24% Average accounting return /year 220.0 Average Investment 1,175.0 Accounting rate of return 18.72% Discounted Payback 4.240 years Details Amt '000 Asset Cost 2,200 Disposal value 150 Average Investment 1,175 Depreciable Value 2,050 Useful Life years 5 Deprecation per year(SL Method) 410 b NPV method ranks the First model higher though both the models are acceptable as both have positive NPV , IRR more than cost of capital. NPV is in synchronization with IRR, discounted payback in this case, so NPV is a good indicator of apprisal parameter in this case. c. Apart from the given information, more information like any risk of cash flow and whether the projected cash flows are risk or probabiliy adjusted , would help in fuller analysis