Capital investment: Acme is planning construction of a new loading ramp for its

Question

Capital investment: Acme is planning construction of a new loading ramp for its single iron mill. The initial cost of the investment is $1 million. Efficiencies from the new ramp are expected to reduce costs by $100,000 for the life of the plant which is currently estimated at another 30 years. When will this project break-even on a simple cash basis and a discounted cash basis. What is the NPV of the project if Acme has an after tax cost of debt of 8% and a cost equity of 12% (they are currently funded equally by debt and equity)? Concept Check: We need to adjust cash flows to account for things like inflation, our cost of capital and opportunity costs. Simply looking at cash flow not adjusted for some of these costs will lead to taking on projects which are not really adding to the value of the organization. Helpful Hint: The first step in conducting an NPV analysis is to include all the relevant cash flows. This includes savings from taxes and any expenses directly related to the venture. We reject any project with a negative NPV.

Explanation / Answer

Discount rate Years Particlulars Amount 10% 0 Cost of investment 1000000 1 1000000 1 Inflows - in the form of savings 100000 0.909091 90909.09091 2 Inflows - in the form of savings 100000 0.8264 82640 3 Inflows - in the form of savings 100000 0.7513 75130 4 Inflows - in the form of savings 100000 0.683 68300 5 Inflows - in the form of savings 100000 0.6209 62090 6 Inflows - in the form of savings 100000 0.5644 56440 7 Inflows - in the form of savings 100000 0.5131 51310 8 Inflows - in the form of savings 100000 0.4665 46650 9 Inflows - in the form of savings 100000 0.424 42400 10 Inflows - in the form of savings 100000 0.3855 38550 11 Inflows - in the form of savings 100000 0.3505 35050 12 Inflows - in the form of savings 100000 0.3186 31860 13 Inflows - in the form of savings 100000 0.2897 28970 14 Inflows - in the form of savings 100000 0.2633 26330 15 Inflows - in the form of savings 100000 0.2393 23930 16 Inflows - in the form of savings 100000 0.2176 21760 17 Inflows - in the form of savings 100000 0.1978 19780 18 Inflows - in the form of savings 100000 0.1798 17980 19 Inflows - in the form of savings 100000 0.1635 16350 20 Inflows - in the form of savings 100000 0.1486 14860 21 Inflows - in the form of savings 100000 0.1331 13310 22 Inflows - in the form of savings 100000 0.1228 12280 23 Inflows - in the form of savings 100000 0.1116 11160 24 Inflows - in the form of savings 100000 0.1015 10150 25 Inflows - in the form of savings 100000 0.0923 9230 26 Inflows - in the form of savings 100000 0.0839 8390 27 Inflows - in the form of savings 100000 0.0763 7630 28 Inflows - in the form of savings 100000 0.0693 6930 29 Inflows - in the form of savings 100000 0.063 6300 30 Inflows - in the form of savings 100000 0.0573 5730 Calculation of cost of capital Debt 8% Total cash outflow        1,000,000 Equity 12% Total cash inflow           942,399 NPV           (57,601) Debt equity ratio 50% Cost of capital We see the presewt value of cash inflows in less than cash outflow (50%*8)+(50%*12) 10% Hence the project is to be rejected This to be used as discount rate for cash inflows

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