Managerial Accounting Questions- Needed in the next 8hrs

EFN406: MANAGERIAL FINANCE

Assignment: Part B, Capital Budgeting 2015 1

Solution

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Answer the two problems below (P1 and P2). Five marks each. Part marks will be allocated, but if you have the incorrect answer then you cannot expect to get more than half marks.

Project 1

Polycorp is considering an investment in new plant of $3.1 million. The project will be financed with a loan of $2,000,000 which will be repaid over the next five years in equal annual end of year instalments at a rate of 6.5 percent pa. Assume straight-line depreciation over a five-year life, and no taxes. The projects cash flows before loan repayments and interest are shown in the table below. Cost of capital is 12.15% pa (the required rate of return on the project). A salvage value of $255,000 is expected at the end of year five and is included in the cash flows for year five below. Ignore taxes and inflation.

You are required to calculate:

(1) The amount of the annual loan repayment and produce a repayment schedule.

(2) NPV of the project (to the nearest dollar)

(3) IRR of the project (as a percentage to two decimal places)

(4) AE, the annual equivalent for the project(AE or EAV) (to the nearest dollar)

(5) PB, the payback and discounted payback in years (to one decimal place)

(6) ARR, the accounting rate of return (gross and net) (to two decimal places)

(7) PI (present value index or profitability index) (to two decimal places)

(8) Is the project acceptable? You must provide a decision or explanation for each of the methods in parts (2) to (7). Why or why not (provide a full explanation)? Also a brief explanation of your treatment of Salvage Value and Loan Repayments is required.

Given:

1. Outlay = 3,100,000 (Investment)

The relevant outlay is the total cost of the project not the amount borrowed or the equity component. (Common errors are to use the amount borrowed 2,000,000 = D or the amount of equity contribution, E = 1,100,000)

2. Cash Flows

Unless otherwise stated these are cash flows before interest and taxes are deducted and do not include salvage value. In this case the questions says that the salvage value is included. Do not deduct repayments or interest as these are financing cash flows and therefore are not relevant.

3. The salvage value at the end of year five is 255,000. The project information says that this is included already in the year five cash flows. A common error is to add it in again.

4. The discount rate for the project is 12.15%. A common error is to use the borrowing rate 6.5%.

5. No taxes and no inflation

See also the excel spreadsheet solution for the Repayment Schedule

(1) Repayment R

R = PV/PVIFA(i = .065, n = 5)

PV = Amount of the Loan = 2,000,000

PVIFA(i = .065, n = 5) = 4.1557

2000000/4.1557

R = $481,269

(2) NPV of the project

NPV = - Outlay +

NPV = -3,100,000 + 880,000/1.1215 + 860,000/1.12152 + 810000/1.12153 + 910,000/1.12154 + 945,000/1.12155

NPV = 50,525

(3) the IRR of the project

At 12.15% the NPV is positive, so the IRR must be greater than 12.15 %.

Try 13%

NPV = -3,100,000 + 880,000/1.13 + 860,000/1.132 + 810000/1.133 + 910,000/1.134 + 945,000/1.135

NPV = -15,334

This is not equal to zero, but is negative, so IRR must be between 12.15 and 13, try 12.5% and so on.

Using the spreadsheet function we get IRR = 12.80%

You could also get close to this solution manually by interpolation, but given that we have an IRR function in a spreadsheet we can be more accurate and we do not need to approximate. So do not use the interpolation method in quizzes or assignments.

(4) The Annual Equivalent for the project(AE or EAV)

AE = NPV/PVIFA(i,n)

AE = 50,525/PVIFA(.1225,5)

PVIFA(.1215,5) = (1-(1+i)-n)/i

AE = 50,525/ 3.591421

AE = 14,068

Common error is to use the debt rate for AE. Use debt rate when doing repayments on debt, use the cost of capital when doing the AE.

(5) The Payback in years (to one decimal place)

After three years the project still owes 550,000. This will come from the year four cash flows of 910,000. So the payback is 3 years and 550,000/910,000

Payback = 3.6

Similarly discounted payback is 4.9, but using discounted cash flows not the raw cash flows.

(6) The Accounting Rate of Return (Gross)

ARRG = Average Annual Profit/Initial investment

Profit here is at the EBIT level. In the question we were provided with cash flow forecast. To calculate ARR we need accounting EBIT forecasts. We must convert the cash flows to profit.

Total Profit = 1,305,000

Average Profit = 261,000

ARRG = 261,000/3,100,000 = 8.42%

ARRN = 261,000/[(3100000+255000)/2] = 15.56%

Note that the SV 255,000 is included in year 5 so it needs to be deducted because it is not revenue for accounting purposes.

(7) PI (present value index or profitability index)

PVI = PV of cash flows/investment

PV of Cash Flows = NPV + Outlay = 50,525 + 3,100,000

PVI = 3,150,525/3,100,000

PVI = 1.0163 or 1.02

(8) Is the project acceptable? Why or why not (provide a full explanation)?

NPV is positive

IRR > 12.15% the cost of capital

AE is positive

PVI is greater than 1.

Therefore accept – the project adds value according to the objective of maximising value.

We have not been given a target for ARR or Payback so we cannot offer any advice to management on these in this case. But we can observe that these methods are unreliable.

It is conceptually incorrect to compare the ARR with the WACC of 12.15%

To get the full marks for this question you would also need to explain your treatment of repayments and interest, and the salvage value.

1

Project 2

Polycorp Limited Steel Division is considering a proposal to purchase a new machine to manufacture a new product for a potential three year contract. The new machine will cost $1.5 million. The machine has an estimated life of three years for accounting and taxation purposes. The contract will not continue beyond three years and the equipment’s estimated salvage value at the end of three years is $128,000. The tax rate is 29 percent and is payable in the year in which profit is earned. An investment allowance of twenty five percent on the outlay is available. The after tax cost of capital is 12.85%pa. Addition net working capital of $72,000 is required immediately for current assets to support the project. Assume that this amount is recovered in full at the end of the three year life of the project. The new product will be charged $59,500 of allocated head office administration costs each year even though head office will not actually incur any extra costs to manage the project. This is in accordance with the firm’s policy of allocating all corporate overhead costs to divisions. Extra marketing and administration cash outflows of $68,500 per year will be incurred by the Steel Division for the project. An amount of $159,000 has been spent on a pilot study and market research for the new product. The projections provided here are based on this work. Projected sales for the new product are 32,000 units at $133 per unit per year. Cash operating expenses are estimated to be 75 percent of sales (excludes marketing and administration, and head office items). Except for initial outlays, assume cash flows occur at the end of each year (unless otherwise stated). Assume diminishing value depreciation for tax purposes.

Required

(a) Construct a table showing your calculations of net cash flow after tax (NCFAT). Use the method shown in lectures and notes.

(b) Calculate the NPV. Is the project acceptable? Why or why not?

(c) Conduct a sensitivity analysis showing how sensitive the project is to operating expenses. Explain.

(d) Write a short report explaining your calculation of relevant net cash flows after tax, justifying your selection of cash flows. Be sure to state clearly any assumptions made (implicit and explicit).