Chapter 14, Problem 32C

To determine

Introduction:

Investment Project

• Investment Projects refer to projects that require a lot of capital expenditure in the form of investments in assets. These projects aim at being profitable and earning the investor a minimum desired return of return.

• Investment Projects can be in shares of companies, plant and machinery that is manufactured or purchased, research and development projects that aim to create new marketable and sellable goods or services.

Incremental Cash Flows

• Incremental Cash Flows refer to cash inflows in the form of cost savings, incomes such as dividends, profits etc. less cash outflows in the form of investments or periodic payments that take effect when an investment project is implemented.

• An investment project seeks to achieve positive Incremental Cash Flows. In the event that the investment project’s Incremental Cash Flows are negative, the investment project will be rejected.

Contribution Margin:

• Contribution Margin refers to the excess of Sales revenues over variable and fixed costs. Since it contributes to the overall profitability of the business it is referred to as contribution margin.

• Variable costs refer to the costs of manufacture that have a direct co-relation with the volume of the goods manufactured, i.e. the costs increase with an increase in the goods produced. Examples are costs of direct material and direct labor.

• Fixed costs refer to the costs of manufacture that have an inverse co-relation with the volume of the goods manufactured, i.e. the costs decrease with an increase in the goods produced. Examples are costs of factory rent, depreciation on plant and equipment

Net Present Value

• Net present value is the discounted value of the difference between the incremental cash inflows and cash outflows. A discounting factor is used to compute the present value of net incremental cash flows and usually the Internal Rate of Return is used as the discounting factor to arrive at the net present value.

• Internal Rate of Return is the minimum desired rate of return which an investment project should achieve. In the event that the investment project’s net present value is lesser than the Internal Rate of Return, the investment project will be rejected.

Net present value of the project