Rounding Limited is a company that is making healthy profits. The firm is contem

Question

Rounding Limited is a company that is making healthy profits. The firm is contemplating introducing a new product line – product X - that is expected to have a life of six years. The firm will have to make an initial investment of $420,000 in the product line, consisting of equipment which is depreciable straight-line to a zero book value. The company uses straight-line depreciation. Marketing experts predict that the company will be able to generate revenue of $180,000 per year. Cash expenses directly associated with the product line will be $84,065 per year. The company tax rate is 30%, and management have determined that the firm must earn an after-tax return of 12% per annum to satisfy its investors.

What is the payback, accounting rate of return, and NPV for product X? Should the firm proceed with this product line?

Explanation / Answer

1. Payback

Payback Period is the number of years it will take to recover the investment made in the project.

The formula for the Payback Period is as follows:

Payback period = Total Investment / Net Annual Cash Inflow

Based on the data in the question, we can substitute the values as below:

Payback Period = $420000 / ($180000-$84065) = 4.38 Years.

The Values substituted above are , Initial Investment = $ 420000, Annual Expected Revenue = $ 180000, Annual Expenses = $ 84065

Please note that Depreciation is a non cash expense and hence is ignored while calculating Payback Period.

2. Accounting Rate of Return

Accounting Rate of Return calculates the expected return on a project or an Investment.

Formula for Accounting Rate of Return is as follows:

Accounting Rate of Return = Average annual Accounting Profit / Initial Investment

In the above formula, Average Annual Accounting Profit is calculated as follows:

Average annual accounting Profit = Expected Revenue - Expected Expenses including depreciation

Let's substitute the values in above formula,

Average annual accounting profit = $180000 - [$84065 + ($420000/6)] = $25935

The values substituted above are, Expected Revenue = $ 18000, Expected Expenses = $84065, Depreciation = Initial Investment / no. of years = $420000/6 Years

Now , Accounting Rate of Return = $25935 / $420000 = 0.06175 = 6.175%

The Values Substituted above are, Average annual accounting Profit = $25935, Initial Investment = $420000

3. NPV (Net Present Value)

NPV is calculated to determine the present value of an investment by the discounted sum of all cash flows expected to receive from the project.

Formula of NPV is as follows:

NPV = -C0 + [C1/(1+r)] + [C2/(1+r)^2] + .........+ [Cn/(1+r)^n]

Where, -C0 = Initial Investment , C = Cash Flow , r = Discount Rate , n = Time

Or one can use Excel to calculate the NPV using the given data. You can use the function NPV in excel and put the values as follows:

Rate = 12% (Expected Post Tax Return)

Value1 = -$420000 (Initial Investment in negative since the amount is an outflow)

Value 2 = $180000-$84065 = $95935 (Expected Annual Revenue - Expected Annual Expense)

Value 3 = $180000-$84065 = $95935 (Expected Annual Revenue - Expected Annual Expense)

Value 4 = $180000-$84065 = $95935 (Expected Annual Revenue - Expected Annual Expense)

Value 5 = $180000-$84065 = $95935 (Expected Annual Revenue - Expected Annual Expense)

Value 6 = $180000-$84065 = $95935 (Expected Annual Revenue - Expected Annual Expense)

Value 7 = $180000-$84065 = $95935 (Expected Annual Revenue - Expected Annual Expense)

The values are taken for 6 years since the life of project is 6 years. Depreciation is not considered since it is a non cash expense.

After subtituting values in excel or in the formula, the NPV of project comes to

NPV = -$22832.27

With the negative NPV, the project will be loss making and hence the company should not proceed with the product line.

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