Question 11: Capital Budgeting Uggle Wuggle Limited is a manuf acturer of machin

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Question 11: Capital Budgeting Uggle Wuggle Limited is a manuf acturer of machine equipment product. The senior management has proposed the purchase of a new set of manufacturing plant that would aid in revolutionizing the equipment manufacturing process, and also the company's products. The company has a capital budget of $55,000,000 maximum. llocated a t otal A consultant has been engaged by the company, and has provided the following summary New equipment if purchased will cost $42,500,000 old 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 s5.114,600 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 receivable will decline by $4,200,500 and accounts payable by S2,650,000. The new equipment is estimated to have a useful life of four years and will depreciated during that span using straight-line depreciation. At the end of five years, it is esti value on the new equipment will be $2,595,000 mated the salvage . The cost of the report from the consultant was $1,500,000. .If the new e value of $1,502,000 per year. The weight average cost of capital of quipment is purchased, it will result in an external rise in sales of a subsidiary to the the company is estimated to be 8%. . Ignore taxation. Required ulir 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 nr lower lustify your answer

Explanation / Answer

Amount $ Explanation Initial purchase -42500000 Cost of new equipment which is an outflow hence negative Salvage value old equipment 4500000 The cash inflow if old equipment is sold immediately Working capital change -1329500 This is the net effect of the change in inventories, accounts receivable and accounts payable shown at the bottom of the solution. An increase in assets and decrease in liabilities is a cash outflow while a decrease in assets and increase in liabilities is a cash inflow. The net effect of the 3 changes is a net outflow of $1329500 Sales increase 12650500 This is the annual increase in sales which is an inflow Variable costs -5114600 Annual increase in cash outflow on account of variable costs Working capital recovery 1329500 This the amount of the net cash outflow on account of working capital which occurred in Year 0 which is now recovered at the end of the useful life of the new equipment at the end of Year 4. Salvage value new equipment 2595000 The cash inflow on account of the sale of the new equipment at the end of its useful life of 4 years. Opportunity salvage cost old equipment -1300000 It is the cost of opportunity foregone of selling the old equipment at the end of Year 4 since it was sold at Year 0 itself for $4500000 and which has been considered as an inflow in Year 0. Cash flow Shows the yearly net cash inflow (positive) or net cash outflow (negative) as a result of all the earlier amounts. Discount rate It is the present value factor of $1 for interest rate of 8% Present value It is the product of the Cash flow x Discount rate NPV -12440557.50 Total (net) of all the present value amounts Note: Working capital change Change in inventory -2880000 Increase in inventory (asset) is a cash outflow Change in accounts receivable 4200500 Decrease in accounts receivable (asset) is a cash inflow Change in accounts payable -2650000 Decrease in accounts payable (liability) is a cash outflow -1329500 Net cash outflow

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