Division D is considering two possible expansion plans. Plan A would expand a cu
ID: 2786896 • Letter: D
Question
Division D is considering two possible expansion plans. Plan A would expand a current product line at a cost of $8,450,000. Expected annual net cash inflows are $1,525,000, with zero residual value at the end of 10 years. Under Plan B, Division D would begin producing a new product at a cost of $8,150,000. This plan is expected to generate net cash inflows of $1,080,000 per year for 10 years, the estimated useful life of the product line. Estimated residual value for Plan B is $1,200,000. Division D uses straight-line depreciation and requires an annual return of 10% a. Compute the payback, the ARR, the NPV, and the profitability index for both plans b. Compute the estimated IRR of Plan A. c. Use Excel to verify the NPV calculations in Requirement 4(a) and the actual IRR for the two plans How does the IRR of each plan compare with the company's required rate of return? Division D must rank the plans and make a recommendation to Dixon's top management team for the best plan. Which expansion plan should Division D choose? Why? d.Explanation / Answer
Payback Period is the no. of years it takes to recover the investment
For A, Payback period = Investment / Annual Cash Flows = 8,450,000 / 1,525,000 = 5.54 years
For B, Payback period = 8,150,000 / 1,080,000 = 7.55 years
Accounting Rate of Return (ARR) = Net Income / Initial Investment = (Cash Inflows - Depreciation) / Initial Investment
For A, Depreciation = Investment / No. of years = 8,450,000 / 10 = 845,000
=> Net Income = 1,525,000 - 845,000 = 680,000
For B, Depreciation = 8,150,000 / 10 = 815,000
=> Net Income = 1,080,000 - 815,000 = 265,000
ARR for A = 680,000 / 8,450,000 = 8.05%
ARR for B = 265,000 / 8,150,000 = 3.25%
NPV can be calculated using PV function in excel or calculator
For A, NPV = PV(rate = 10%, nper = 10, pmt = -1,525,000, fv = 0, 0) - 8,450,000 = $920,464.84
For B, NPV = PV(rate = 10%, nper = 10, pmt = -1,080,000, fv = -1,200,000, 0) - 8,150,000 = -$1,051,215.58
Profitability Index (PI) = 1 + NPV / Initial Investment
For A, PI = 1 + 920,464.84 / 8,450,000 = 1.11
For B, PI = 1 + (-1,051,215.58) / 8,150,000 = 0.87
IRR can be calculated using RATE function in excel
For A, IRR = RATE(nper = 10, pmt = 1,525,000, pv = -8,450,000, fv = 0, 0) = 12.48%
For B, IRR = RATE(nper = 10, pmt = 1,080,000, pv = -8,150,000, fv = 1,200,000, 0) = 7.11%
Division D should choose Plan A as it has higher NPV than Plan B and its IRR > 10%