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Explain how calculations were made step by step numbers only Expert Q&A; Done Question 11: Capital Budgeting Uggle Wuggle Limited is a manufacturer of proposed the purchase of a new set of manufacturing plant that would aid in revolutionizing the machine equipment manufacturing process, capital budget of $5,00,000 maximum machine equipment product. The senior management has and also the company's products. The company has allocated a total A consultant has been engaged by the company, and has provided the following summary New equipment if purchased will cost $42,500,000 Oid equipment currently planned to be sold for $1,300,000 in four years could be sold immediately for a salvage value of $4,500,000. It is estimated that the purchase of the new equipment will result in an increase of sales of 12,650,500 per year Variable costs will also increase by $5.114,600 per year if the new equipment is purchased Fixed costs will remain constant. . If the new equipment is purchased, then this will increase the level of inventory immediately by S2.880,000 whilst accounts reccivable will decline by $4,200,500 and accounts payable by 52,650,000 The new equipment is estimated to have a useful life of four years and will depreciated to zero during that span using straight-line depreciation. At the end of five years, it is estimated the salvage value on the new equipment will be $2,595,000 . The cost of the report from the consultant was $1,500,000 . If the new equipment is purchased, it will result in an external rise in sales of a subsidiary to the valuc of $1,502,000 per year The weight average cost ofcapital of the company is estimated to be 8% * Ignore taxation Required: (1) Calculate the net present value of proposed purchase of the new equipment. (2) Based on your calculation in Part (1), is the internal rate of return (IRR) of the project higher or lower. Justify your answer (3) One of the senior management is concemod that the consultant's calculation of the weighted- average cost of capital is too high and suggests applying a lower rate. If a lower rate is used, what will be the impact on the NPV you calculated in Part (1) (4) Another director has suggested the company should invest in another set of equipment that would be independent of the initial suggestion. The director has said the alternative equipment to be purchased would yield an IRR or145% Based on the weightedeverage cost of capital calculated accept or reject the alternative proposition from the director? Justify by the consultant, would you your answer junior executive has also suggested it would be more optional for the company to invest in a revolutionary picce of machinery that would yield a significantly higher positive NPV than any of other suggested projects. The initial outlay for this revolutionary equipment is $62,600,000. suggestod purchase yielded a positive NPV (ignore your computation in Part you support the purchase recommended by the junior IT executive? Justify your answer Assuming the initial (1)), would 15

Explanation / Answer

1) Formula for NPV: -Initial investment + [(Cash Inflow1)/(1+r)1] + [(Cash Inflow2)/(1+r)2] + [(Cash Inflow3)/(1+r)3]…..+ [(Cash Inflown)/(1+r)n]

Change in net working capital requirements = Decline in Accounts receivable – Decline in Accounts Payable – Increase in inventory
= $4,200,500 + $2,880,000 - $2,650,000 = $1,329,500

Initial Investment = Cost of new equipment – Proceeds from old equipment sales + Change in Working Capital
=> $42,500,000 - $4,500,000 + $1,329,500 = $39,329,500

Increase in sales = $12,650,500
Increase in variable cost = $5,114,600

Net annual cash-flow through Year 1 to Year 3 = Increase in sales - Increase in variable cost
=> $14,152,500 - $5,114,600 = $7,535,900

Net cash-flow in year 4 = Increase in sales - Increase in variable cost + Recovery of Net Working Capital + Salvage value of new equipment – Foregone salvage value of old equipment
=> $14,152,500 - $5,114,600 + $1,329,500 + $2,595,000 - $1,300,000 = $10,160,400

NPV:
-$39,329,500 + ($7,535,900/1.08) + ($7,535,900/1.082) + ($7,535,900/1.083) + ($10,160,400/1.084) = -$12,440,557.50

2) Calculation of Internal Rate of Return using interpolation method:

Formula: -Initial Cash Outlay + Present Value of all Future Cash Inflows = 0

0 = -$39,329,500 + {$7,535,900/(1+IRR)} + {$7,535,900/(1+IRR2)} + {$7,535,900/(1+IRR3)} + {$10,160,400/(1+IRR4)}

IRR = -6.62%

3) If a lower rate is used as cost of capital, the NPV will increase, since the lower discounted rate would result in higher present values of cash-flows in future years.

4) IRR stands for “Internal Rate of Return”, which is a return rate that a project derives. IRR is primarily compared with cost of capital. An IRR greater than cost of capital means that the project would produce positive profits and vice-versa.

Since the alternative equipment is expected to result in an IRR of 14.5%, it must be purchased as the cost of capital is only 8%.

5) NPV tells us how much a project would worth today by discounting all the future cash-flows and deducting all the associated costs such as initial investment, annual expenses etc. In a situation, wherein you have more than one investment alternative, you should always go for the project that is expected to generate highest NPV, irrespective of the level of investment.

Since the suggested machinery would result in highest positive NPV, it must be opted for.

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