Question 2: Custom Foundries Ltd. (CFL), have identified a market opportunity to

Question

Question 2: Custom Foundries Ltd. (CFL), have identified a market opportunity to sell specialised dual valve couplings to the utility sector, which would incur the addition of a new production process in the business. After an appraisal of this now business project, a cross-functional team has produced the following information: Currently, CFL enjoys a 24% p.a. return on capital, and is not interested in Investments that would dilute this annual return, by having returns of less than 24% on any new capital projects. Furthermore, CFL looks at new projects on a max 5-year time scale, and have estimated that its net proceeds of liquidating this venture at the end of 5 years would be 50,000. Required: (a) Set out a table showing the net income flows over the five years of this project, and the NPV. (75 marks) (b) Based on your results to the above, comment on the investment in light of CFLs policies; and also on the general issues of using this form of capital investment appraisal. (25 marks)

Explanation / Answer

13263.94459

Net income flows = 422500 and NPV = 13263.94459

b.

Since after floowing the CFL's policies the project provides a positive NPV of 13263.94459 therefore the project is acceptable.

The issues in CFL's policy are that CFL looks on new project at max 5 year time scale. These can prove wrong if the project is having life of more than five years and if cash flows increases with increase in time. CFL should look into whether the project will provide cash inflow after year 5 or not.

Also general issue in these form of capital investment appraisal is that they are based on estimate. If the estimate goes wrong the decision we took based on that estimate can also go wrong as in these case the units sold are increasing every year and therefore the cash flows in the beginning few years are comparatively very less than cash flows in the last few years these can also be seen from difference in net cash flows (422500) and discounted cash flow (13263), if our estimate of increasing cash flows is incorrect than we can have a negative NPV and our accepting decision of these project will be incorrect.

Contribution per unit = 225-40-90 = 95 per unit Fixed Other cost per annum = 130000 + 180000 + 165000 = 475000 Capital investment in new plant = 340000 Net Income flows over the 5 years and NPV Year Units Contribution per unit Other fixed cost p.a Net cash flow Discounting factor Discounted cash flow 0 0 0 0 -340000 1 -340000 1 5500 522500 475000 47500 0.806452 38306.45161 2 6000 570000 475000 95000 0.650364 61784.59938 3 6500 617500 475000 142500 0.524487 74739.43473 4 7000 665000 475000 190000 0.422974 80364.98358 5 7500 712500 475000 237500 0.341108 81013.08829 5 0 0 0 50000 0.341108 17055.38701 Total 422500

13263.94459

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