T Co plans to buy a machine to make new product. The machine will cost $250,000
ID: 2784867 • Letter: T
Question
T Co plans to buy a machine to make new product. The machine will cost $250,000 and last for four
years, at the end of which time it will be sold for $5,000. T Co expects demand for the product to be:
Year Demand (units)
1 35,000
2 40,000
3 50,000
4 25,000
The selling price is expected to be $12.00/unit and the variable cost of production is expected to be $7.80/unit. Incremental annual fixed production overheads = $25,000 per year. Selling price and costs are all in current price terms. Selling price and costs are expected to increase as follows
Selling price : 3% per year; variable cost: 4% per year
Fixed production overheads: 6% per year
Requirement: Calculate the ROCE (T Co's target ROCE = 20%) and state based on this, whether the investment should proceed.
Explanation / Answer
The machine will cost $250,000 and thus capital employed will be $250,000
and the machine lasts 4 years thus based on SLM, depreciation will be 250000/4=62500 per year
The selling price for year 1=12 which will increase at 3% per year and thus the formula will be 12(1.03)^n-1
Year 1: 12(1.03)^1-1 = 12(1.03)^0 = 12
Year 2: 12(1.03)^2-1 = 12(1.03)^1 = 12.36
Year 3: 12(1.03)^3-1 = 12(1.03)^2 = 12.73
Year 4: 12(1.03)^4-1 = 12(1.03)^3 = 13.11
The variable cost for year1=7.80 which will increase at 4% per year and thus the formula will be 7.80(1.04)^n-1
Year 1: 7.08(1.04)^1-1 = 7.08(1.04)^0 = 7.08
Year 2: 7.08(1.04)^2-1 = 7.08(1.04)^1 = 7.36
Year 3: 7.08(1.04)^3-1 = 7.08(1.04)^2 = 7.66
Year 4: 7.08(1.04)^4-1 = 7.08(1.04)^3 = 7.96
The variable cost for year1=25000 which will increase at 6% per year and thus the formula per unit will be (25000(1.06)^n-1)/demand units
Year 1: (25000(1.06)^1-1)/35000 = (25000(1.06)^0)/35000 = 0.71
Year 2: (25000(1.06)^2-1)/35000 = (25000(1.06)^1)/35000 = 0.76
Year 3: (25000(1.06)^3-1)/35000 = (25000(1.06)^2)/35000 = 0.80
Year 4: (25000(1.06)^4-1)/35000 = (25000(1.06)^3)/35000 = 0.85
For ROCE and NPV calculation see the spreadsheet below:
EBIT=(sales-variablecost-fixedcost)*demand units
EBITDA=EBIT-Depreciation
ROCE=EBITDA for the year/250000
For final year its EBITDA+salvage of 5000
Year
Demand units
Sales
Variable cost
Fixed cost
EBIT
Depreciation
EBITDA
ROCE
Cashflows
-250000
1
35000
12
7.08
0.71
147350
62500
84850
33.940%
84850
2
40000
12.36
7.36
0.76
169600
62500
107100
42.840%
107100
3
50000
12.73
7.66
0.80
213500
62500
151000
60.400%
151000
4
25000
13.11
7.96
0.85
107500
62500
45000
18.000%
50000
-$11,700.00
EBIT=(sales-variablecost-fixedcost)*demand units
EBITDA=EBIT-Depreciation
ROCE=EBITDA for the year/250000
For final year its EBITDA+salvage of 5000
Year
Demand units
Sales
Variable cost
Fixed cost
EBIT
Depreciation
EBITDA
ROCE
Cashflows
-250000
1
35000
12
7.08
0.71
147350
62500
84850
33.940%
84850
2
40000
12.36
7.36
0.76
169600
62500
107100
42.840%
107100
3
50000
12.73
7.66
0.80
213500
62500
151000
60.400%
151000
4
25000
13.11
7.96
0.85
107500
62500
45000
18.000%
50000
-$11,700.00
The target ROCE is 20% for the company and thus the NPV using 20% discount rate is -11700 and thus the project should be accepted and investment shouldnt be proceeded.Related Questions
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