A food processing shop in Accra (Biem) is considering adding a new line and you

Question

A food processing shop in Accra (Biem) is considering adding a new line and you are hired to conduct the capital budgeting analysis. Biem needs to increase production capacity to meet increasing demand for an existing products, ‘Quado’, which is used in food processing. A new machine, with a useful life of four years and a maximum output of 600,000 kg of Quado per year, could be bought for GHC 800,000, payable immediately. The scrap value of the machine after four years would be GHC30,000. Biem is in the 25 percent tax bracket. Forecast demand and production of Quado over the next four years is as follows:

Year                    1             2           3              4
Demand (kg)     1.4m      1.5m     1.6m       1.7m
where m is million.

Existing capacity for Quado is limited to one million kilograms per year. The current selling price of Quado is GHC8.00 per kilogram and variable cost of materials is GHC 5.00 per kilogram. Other variable costs of production are GHC 1.90 per kilogram. Fixed costs of production associated with the new machine would be GHC 240,000 in the first year of production, increasing by GHC 20,000 per year in each subsequent year of operation.

Biem charges depreciation of 25 percent on straight line basis and this is tax allowable. Biem uses its after-tax weighted average cost of capital of 10 percent when appraising investment projects. Is the proposed machine purchase suitable for Biem? What will your decision be if the discount rates are 5 percent, 15 percent 20 per cent and 25 percent?

Explanation / Answer

Cash flow from operation Year 1 Year 2 Year 3 Year 4 Incremental Sale 400000 500000 600000 700000 Sales (Qty *Sale price) 3200000 4000000 4800000 5600000 Less : Variable cost( Qty*Variable cost) -2000000 -2500000 -3000000 -3500000 Fixed cost -240000 -260000 -280000 -300000 Depreciation (800000-30000)/4 -192500 -192500 -192500 -192500 Scrap Value 30000 Net Income before tax 767500 1047500 1327500 2337500 Less : Tax @ 25% 191875 261875 331875 584375 Net Income after tax 575625 785625 995625 1753125 Add : Depreciation 192500 192500 192500 192500 Free cash flow from operation 768125 978125 1188125 1945625 If Discount rate is 10%, the NPV would be Year Cash flow Discounting factor @ 10% Present value 0 -800000 1 -800000 1 768125 0.909091 698295.5 2 978125 0.826446 808367.8 3 1188125 0.751315 892655.9 4 1945625 0.683013 1328888 NPV 2928207 Since the NPV is $ 2928207, the machine is suitable for Biem If Discount rate is 5%, the NPV would be Year Cash flow Discounting factor @ 5% Present value 0 -800000 1 -800000 1 768125 0.952381 731547.6 2 978125 0.907029 887188.2 3 1188125 0.863838 1026347 4 1945625 0.822702 1600671 NPV 3445753 Since the NPV is $ 3445753, the machine is suitable for Biem If Discount rate is 15%, the NPV would be Year Cash flow Discounting factor @ 15% Present value 0 -800000 1 -800000 1 768125 0.869565 667934.8 2 978125 0.756144 739603 3 1188125 0.657516 781211.5 4 1945625 0.571753 1112417 NPV 2501167 Since the NPV is $ 2501167, the machine is suitable for Biem If Discount rate is 20%, the NPV would be Year Cash flow Discounting factor @ 20% Present value 0 -800000 1 -800000 1 768125 0.833333 640104.2 2 978125 0.694444 679253.5 3 1188125 0.578704 687572.3 4 1945625 0.482253 938283.7 NPV 2145214 Since the NPV is $ 2145214, the machine is suitable for Biem If Discount rate is 25%, the NPV would be Year Cash flow Discounting factor @ 25% Present value 0 -800000 1 -800000 1 768125 0.8 614500 2 978125 0.64 626000 3 1188125 0.512 608320 4 1945625 0.4096 796928 NPV 1845748 Since the NPV is $ 1845748, the machine is suitable for Biem

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