HDW Co is a listed company which plans to meet increased demand for its products by buying new machinery costing £5 million. The machinery would last for four years, at the end of which it would be replaced. The scrap value of the machinery is expected to be 5% of the initial cost. Capital allowances would be available on the cost of the machinery on a 25% reducing balance basis, with a balancing allowance or charge claimed in the final year of operation. This investment will increase production capacity by 9,000 units per year and all of these units are expected to be sold as they are produced. Relevant financial information in current price terms is as follows: Selling price £650 per unit with inflation 7·0% per year Variable cost £250 per unit with inflation 7·5% per year Incremental fixed costs £250,000 per year with inflation 8·0% per year In addition to the initial cost of the new machinery, initial investment in working capital of £800,000 will be required. Investment in working capital will be subject to the general rate of inflation, which is expected to be 7·7% per year. HDW Co pays tax on profits at the rate of 20% per year, one year in arrears. The company has a nominal (money terms) after-tax cost of capital of 12% per year. Question one a. Critique the Investment appraisal techniques available to the company in calculating the potential return from the project. b. Identify TWO financial objectives of a listed company such as HDW Co and discuss how each of these financial objectives is supported by the planned investment in new machinery.
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.
HDW Co is a listed company which plans to meet increased demand for its products by buying new machinery costing £5 million.
The machinery would last for four years, at the end of which it would be replaced. The scrap value of the machinery is expected to be 5% of the initial cost.
Capital allowances would be available on the cost of the machinery on a 25% reducing balance basis, with a balancing allowance or charge claimed in the final year of operation.
This investment will increase production capacity by 9,000 units per year and all of these units are expected to be sold as they are produced.
Relevant financial information in current price terms is as follows:
Selling price £650 per unit with inflation 7·0% per year
Variable cost £250 per unit with inflation 7·5% per year
Incremental fixed costs £250,000 per year with inflation 8·0% per year
In addition to the initial cost of the new machinery, initial investment in working capital of £800,000 will be required.
Investment in working capital will be subject to the general rate of inflation, which is expected to be 7·7% per year.
HDW Co pays tax on profits at the rate of 20% per year, one year in arrears.
The company has a nominal (money terms) after-tax cost of capital of 12% per year.
Question one
a. Critique the Investment appraisal techniques available to the company in calculating the potential return from the project.
b. Identify TWO financial objectives of a listed company such as HDW Co and discuss how each of these financial objectives is supported by the planned investment in new machinery.
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