DEF Ltd is currently considering an investment in a new project named Project Two. The project would involve an immediate purchase of capital equipment costing €1.5m. This equipment is expected to have a residual value in five years of €150,000, and will be depreci- ated over five years on a straight line basis. Sales of the new product will be €1.4m per annum for five years. DEF Ltd earns a contribu- tion of 45% on sales. The new product would require that a project manager be recruited at a salary of €50,000 per annum and the company will have to make annual contributions of €12,000 to fund the man- ager’s pension benefits. The new product will require an investment of €300,000 in working capital at the start of the project with a further €40,000 at the start of year two. Annual fixed overheads (excluding depreciation) relating to the new product are estimated at €65,000 and in addition there will be an allocation of central fixed overheads of €50,000. Research and development costs of €120,000 have been incurred already, although this in- voice has not yet been paid. Staff training costs of €30,000 are projected in year one of the project. Taxation DEF’s Financial Director has provided the following taxation information: Tax depreciation : 25% per annum reducing balance, with a balancing charge or al- lowance at the year disposal Taxation rate : 30% of taxable profits. Half of the tax is payable in the year in which it occurs, the balance is paid in the following year. Other information Cost of capital 12% per annum is used to evaluate projects of this type. Inflation is expected to be 4% per annum throughout the life of the project on revenues and costs (beginning in Year 2) Evaluate whether DEF should go ahead with the investment project. You should use Net Present Value as the basis of your evaluation. Your workings should be rounded to the nearest $’000. Calculate the Internal Rate of Return for the Project and its relevance to this proposal Calculate the Payback for the Project and its relevance to this proposal.
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
DEF Ltd is currently considering an investment in a new project named Project Two.
The project would involve an immediate purchase of capital equipment costing €1.5m. This equipment is expected to have a residual value in five years of €150,000, and will be
Sales of the new product will be €1.4m per annum for five years. DEF Ltd earns a contribu- tion of 45% on sales.
The new product would require that a project manager be recruited at a salary of €50,000 per annum and the company will have to make annual contributions of €12,000 to fund the man- ager’s pension benefits.
The new product will require an investment of €300,000 in working capital at the start of the project with a further €40,000 at the start of year two.
Annual fixed overheads (excluding depreciation) relating to the new product are estimated at €65,000 and in addition there will be an allocation of central fixed overheads of €50,000.
Research and development costs of €120,000 have been incurred already, although this in- voice has not yet been paid.
Staff training costs of €30,000 are projected in year one of the project.
DEF’s Financial Director has provided the following taxation information:
-
Tax depreciation : 25% per annum reducing balance, with a balancing charge or al- lowance at the year disposal
-
Taxation rate : 30% of taxable profits. Half of the tax is payable in the year in which it occurs, the balance is paid in the following year.
Other information
-
Cost of capital 12% per annum is used to evaluate projects of this type.
-
Inflation is expected to be 4% per annum throughout the life of the project on revenues
and costs (beginning in Year 2)
-
Evaluate whether DEF should go ahead with the investment project. You should use
Net Present Value as the basis of your evaluation. Your workings should be rounded to the nearest $’000. -
Calculate the
Internal Rate of Return for the Project and its relevance to this proposal -
Calculate the Payback for the Project and its relevance to this proposal.
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