A company is considering manufacturing a new product. They would be leasing a bu

Question

A company is considering manufacturing a new product. They would be leasing a building at a cost of $20,000 per year. The equipment would cost $300,000 and an extra $100,000 would be needed in working capital. The annual expenses for material, labor and all other overhead is expected to be $500,000 per year. The annual revenue from this new product is expected to be $600,000 for the first year and increase by $20,000 each year after the first year. The company expects to produce this product for the next ten years. After that the equipment can be sold for $20,000 and the entire working capital would also be recovered. If the MARR is 20% per year compounded yearly, should the company invest in the new product?

Explanation / Answer

It is a problem on capital budgeting. Company is considering, maufacturing of a new product. For this purpose it requires a building. It has been taken at $20,000 annual lease. Equipment required is $300,000. Working capital is $20,0000. Company will earn revenuers of $600,000 on year 1 and then it will increase by $20,000 each year. Expenses are $500,000 per year. Life is 10 years. Equipment can be sold at $20,000 after 10 years.

This problem can be solved on the basis of NPV method. Net present value (NPV) is the present value of life time cash inflows minus initial outflow. MARR is considered in present value calculation., It is the miimum required rates of return to satisfy the investors. If NPV is positive, then earnings from project is something more than minimum required rate of return. It will help the firm in maximizing its value. So the project will be accepted.

Based on above concepts, calculations are shown below:

Answer: Since Net present value is positive, company should invest in the project.

Statement showing calculation of net present value (NPV) of the project Year Cost of Working Annual Material, Lease Total Net Scrap Net cash Discounting Present equipment capital Revenues Labor etc Rent expenses Cash flows value flows factors value (1) (2) (3) (4) (5) (6) (7)=(5)+(6) (8)=(4)-(7) (9) (10)=(2)+(3)+(8)+(9) (11) (12) 0 ($300,000) ($100,000) ($400,000) 1 ($399,999) 1 $600,000 ($500,000) ($20,000) ($520,000) $80,000 $80,000 0.8333333 66666.667 2        620,000 ($500,000) ($20,000) ($520,000) $100,000 $100,000 0.6944444 69444.444 3        640,000 ($500,000) ($20,000) ($520,000) $120,000 $120,000 0.5787037 69444.444 4        660,000 ($500,000) ($20,000) ($520,000) $140,000 $140,000 0.4822531 67515.432 5        680,000 ($500,000) ($20,000) ($520,000) $160,000 $160,000 0.4018776 64300.412 6        700,000 ($500,000) ($20,000) ($520,000) $180,000 $180,000 0.334898 60281.636 7        720,000 ($500,000) ($20,000) ($520,000) $200,000 $200,000 0.2790816 55816.329 8        740,000 ($500,000) ($20,000) ($520,000) $220,000 $220,000 0.232568 51164.969 9        760,000 ($500,000) ($20,000) ($520,000) $240,000 $240,000 0.1938067 46513.608 10 $100,000        780,000 ($500,000) ($20,000) ($520,000) $260,000 $20,000 $380,000 0.1615056 61372.121     Net present value (sum) $212,521

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