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<p>4 SC Co is evaluating the purchase of a new machine to produce product P, which has a short product life-cycle due<br/>to rapidly changing technology. The machine is expected to cost $1 million. Production and sales of product P are<br/>forecast to be as follows:<br/>Year 1 2 3 4<br/>Production and sales (units/year) 35,000 53,000 75,000 36,000<br/>The selling price of product P (in current price terms) will be $20 per unit, while the variable cost of the product (in<br/>current price terms) will be $12 per unit. Selling price inflation is expected to be 4% per year and variable cost<br/>inflation is expected to be 5% per year. No increase in existing fixed costs is expected since SC Co has spare capacity<br/>in both space and labour terms.<br/>Producing and selling product P will call for increased investment in working capital. Analysis of historical levels of<br/>working capital within SC Co indicates that at the start of each year, investment in working capital for product P will<br/>need to be 7% of sales revenue for that year.<br/>SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax is reduced by capital<br/>allowances on machinery (tax-allowable depreciation), which SC Co can claim on a straight-line basis over the<br/>four-year life of the proposed investment. The new machine is expected to have no scrap value at the end of the<br/>four-year period.<br/>SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.<br/>Required:<br/>(a) Calculate the net present value of the proposed investment in product P. (12 marks)<br/>(b) Calculate the internal rate of return of the proposed investment in product P. (3 marks)<br/>(c) Advise on the acceptability of the proposed investment in product P and discuss the limitations of the<br/>evaluations you have carried out. (5 marks)<br/>(d) Discuss how the net present value method of investment appraisal contributes towards the objective of<br/>maximising the wealth of shareholders. (5 marks)<br/>(25 marks)</p><p></p><p>4 (a) Calculation of net present value<br/>Year 0 1 2 3 4<br/>$ $ $ $ $<br/>Sales revenue 728,000 1,146,390 1,687,500 842,400<br/>Variable costs (441,000) (701,190) (1,041,750) (524,880)<br/>––––––––– –––––––––– ––––––––––– –––––––––<br/>Contribution 287,000 445,200 645,750 317,520<br/>Capital allowances (250,000) (250,000) (250,000) (250,000)<br/>––––––––– –––––––––– ––––––––––– –––––––––<br/>Taxable profit 37,000 195,200 395,750 67,520<br/>Taxation (11,100) (58,560) (118,725) (20,256)<br/>––––––––– –––––––––– ––––––––––– –––––––––<br/>After-tax profit 25,900 136,640 277,025 47,264<br/>Capital allowances 250,000 250,000 250,000 250,000<br/>––––––––– –––––––––– ––––––––––– –––––––––<br/>After-tax cash flow 275,900 386,640 527,025 297,264<br/>Initial investment (1,000,000)<br/>Working capital (50,960) (29,287) (37,878) 59,157 58,968<br/>––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––<br/>Net cash flows (1,050,960) 246,613 348,762 586,182 356,232<br/>Discount at 12% 1·000 0·893 0·797 0·712 0·636<br/>––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––<br/>Present values (1,050,960) 220,225 277,963 417,362 226,564<br/>––––––––––– ––––––––– –––––––––– ––––––––––– –––––––––<br/>NPV = $91,154</p><p>Workings<br/>Sales revenue<br/>Year 1 2 3 4<br/>Selling price ($/unit) 20·80 21·63 22·50 23·40<br/>Sales volume (units) 35,000 53,000 75,000 36,000<br/>Sales revenue ($) 728,000 1,146,390 1,687,500 842,400<br/>Variable costs<br/>Year 1 2 3 4<br/>Variable cost ($/unit) 12·60 13·23 13·89 14·58<br/>Sales volume (units) 35,000 53,000 75,000 36,000<br/>Variable costs ($) 441,000 701,190 1,041,750 524,880<br/>Total investment in working capital<br/>Year 0 investment = 728,000 x 0·07 = $50,960<br/>Year 1 investment = 1,146,390 x 0·07 = $80,247<br/>Year 2 investment = 1,687,500 x 0·07 = $118,125<br/>Year 3 investment = 842,400 x 0·07 = $58,968<br/>Incremental investment in working capital<br/>Year 0 investment = 728,000 x 0·07 = $50,960<br/>Year 1 investment = 80,247 – 50,960 = $29,287<br/>Year 2 investment = 118,125 – 80,247 = $37,878<br/>Year 3 recovery = 58,968 – 118,125 = $59,157<br/>Year 4 recovery = $58,968<br/>(b) Calculation of internal rate of return<br/>Year 0 1 2 3 4<br/>$ $ $ $ $<br/>Net cash flows (1,050,960) 246,613 348,762 586,182 356,232<br/>Discount at 20% 1·000 0·833 0·694 0·579 0·482<br/>––––––––––– –––––––– –––––––– –––––––– ––––––––<br/>Present values (1,050,960) 205,429 242,041 339,399 171,704<br/>––––––––––– –––––––– –––––––– –––––––– ––––––––<br/>NPV at 20% = ($92,387)<br/>NPV at 12% = $91,154<br/>IRR = 12 + [(20 – 12) x 91,154/(91,154 + 92,387)] = 12 + 4 = 16%<br/>(c) Acceptability of the proposed investment in Product P<br/>The NPV is positive and so the proposed investment can be recommended on financial grounds.<br/>The IRR is greater than the discount rate used by SC Co for investment appraisal purposes and so the proposed investment<br/>is financially acceptable. The cash flows of the proposed investment are conventional and so there is only one internal rate<br/>of return. Furthermore, only one proposed investment is being considered and so there is no conflict between the advice<br/>offered by the IRR and NPV investment appraisal methods.<br/>Limitations of the investment evaluations<br/>Both the NPV and IRR evaluations are heavily dependent on the production and sales volumes that have been forecast and<br/>so SC Co should investigate the key assumptions underlying these forecast volumes. It is difficult to forecast the length and<br/>features of a product’s life cycle so there is likely to be a degree of uncertainty associated with the forecast sales volumes.<br/>Scenario analysis may be of assistance here in providing information on other possible outcomes to the proposed investment.<br/>The inflation rates for selling price per unit and variable cost per unit have been assumed to be constant in future periods. In<br/>reality, interaction between a range of economic and other forces influencing selling price per unit and variable cost per unit<br/>will lead to unanticipated changes in both of these project variables. The assumption of constant inflation rates limits the<br/>accuracy of the investment evaluations and could be an important consideration if the investment were only marginally<br/>acceptable.<br/>Since no increase in fixed costs is expected because SC Co has spare capacity in both space and labour terms, fixed costs<br/>are not relevant to the evaluation and have been omitted. No information has been offered on whether the spare capacity<br/>exists in future periods as well as in the current period. Since production of Product P is expected to more than double over<br/>three years, future capacity needs should be assessed before a decision is made to proceed, in order to determine whether<br/>any future incremental fixed costs may arise.<br/>(d) The primary financial management objective of private sector companies is often stated to be the maximisation of the wealth<br/>of its shareholders. While other corporate objectives are also important, for example due to the existence of other corporate<br/>stakeholders than shareholders, financial management theory emphasises the importance of the objective of shareholder<br/>wealth maximisation.</p><p>Shareholder wealth increases through receiving dividends and through share prices increasing over time. Changes in share<br/>prices can therefore be used to assess whether a financial management decision is of benefit to shareholders. In fact, the<br/>objective of maximising the wealth of shareholders is usually substituted by the objective of maximising the share price of a<br/>company.<br/>The net present value (NPV) investment appraisal method advises that an investment should be accepted if it has a positive<br/>NPV. If a company accepts an investment with a positive NPV, the market value of the company, theoretically at least,<br/>increases by the amount of the NPV. A company with a market value of $10 million investing in a project with an NPV of<br/>$1 million will have a market value of $11 million once the investment is made. Shareholder wealth is therefore increased<br/>if positive NPV projects are accepted and, again theoretically, shareholder wealth will be maximised if a company invests in<br/>all projects with a positive NPV. This is sometimes referred to as the optimum investment schedule for a company.<br/>The NPV investment appraisal method also contributes towards the objective of maximising the wealth of shareholders by<br/>using the cost of capital of a company as a discount rate when calculating the present values of future cash flows. A positive<br/>NPV represents an investment return that is greater than that required by a company’s providers of finance, offering the<br/>possibility of increased dividends being paid to shareholders from future cash flows.</p> ding <p>see</p> HAOsee
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