This is an extra credit assignment I was assigned that I really need the points for. I am having alot of trouble with it. I did a few of the questions but im not sure if they are right or not and I don't know how to do a few.
For number 1 (Listed below)
Payback = $46 million/$4 million = 11.5 years
NPV = (6.623 x $44 million) - $46 million
= 291.412 - 4.6 million
= $ 245.412 million
(*Note: I found that the discount factor for annuity with required rate of return at 14% and usful life of the project at 20 years is 6.623 in my accounting book)
I'm not sure if that is how you calculate it or not though.
For number 2 I took the 245.412 million and added the production and marketing savings to it:
245.412 million + 1 million + 2.5 million
=248.912 million
again im not sure if i did this right either.
number 3:
Payback = 50/7.5 million = 6.67 years
NPV= [6.623 x (7.5 x 6.67) - 50
=331.316 - 50
=281.316
I feel like none of those answers are even close to right though. I really don't understand this. Could someone please help me out?
At a recent executive meeting at Bertown Co, a manufacturer of parts for the auto industry, Kathy Wathy (VP of Finance) insisted that “if we are going to be competitive, we need to build this proposed completely automated plant.”
Steve Reeve (Bertown CEO) was not so sure. “The savings from labor reductions and increased productivity are expected to be $4 million annually. The price tag for this plant (and it is a small facility) is $46 million. That generates a payback period of more than 11 years, which is a long time to put the company’s money at risk.”
Sam Slam, the production manager, interjected that “Yes, but you are overlooking the savings that we will get from the increase in quality. With this system, we can decrease our waste and our rework time significantly. Those savings have to be worth another $1 million per year.”
“Another $1 million will decrease the payback to about nine years,” Steve replied. “Ron, as the marketing manager, do you have any insights?”
“Well, there are other factors to consider, such as service quality and market share,” said Ron John. “I think that increasing our product quality and improving our delivery service will make us a lot more competitive. I know for a fact that two of our competitors have decided against automation. That will give us a shot at their customers, provided our product is of higher quality and we can deliver it faster. I estimate that it will increase our net cash benefits by another $2.5 million annually.”
“Wow! Now that is more like it,” exclaimed Steve. “The payback is now getting down to a reasonable level.”
“I agree,” said Kathy, “but we do need to be sure that it is a sound investment. I know that the estimates for the construction of the facility have gone as high as $50 million. I also know that the expected residual value, after the 20 years of expected service, is around $6 million. I will see if this project can cover our 10 percent cost of capital requirement.”
“Wait,” said Steve, “there is a great deal of risk and uncertainty surrounding our estimates. We had better assess the project’s prospects at 14 percent, rather than the 10 percent normal cost of capital requirement.”
You work as a management accountant at Bertown. Kathy discussed much of the results of the meeting with you and asked you to provide the following information:
Required:
1.Determine the NPV and payback of the project using the original savings and investment estimates, at 14 percent.
2.Determine the NPV and payback of the project adding in (to the information in part 1 above) the additional savings suggested by production and marketing, at 14 percent.
3.Determine the NPV and payback of the project using all of the information from part 2 (above), with the amount of the investment at the higher estimate of $50 million, at 14 percent.
4.Address the the following issues:
a.Make a recommendation regarding the investment, based on your data from (1) – (3) above.
b.Identify and briefly discuss two (2) other ways that the company could deal with risk and uncertainty regarding this project (besides increasing the required rate of return).
c.Identify and briefly discuss what you believe are the two most important qualitative issues related to this project (make sure you explain why).
To calculate the NPV and payback for the project at 14 percent, we need to follow these steps:
1. Determine the cash flows: The cash flows for this project are the annual savings mentioned in the meeting. In this case, it's $4 million per year for labor reductions and increased productivity.
2. Calculate the payback period: The payback period is the amount of time it takes for the initial investment to be recovered. To find the payback period, divide the initial investment ($46 million) by the annual cash flows ($4 million).
Payback = $46 million / $4 million = 11.5 years
So, the payback period for this project is 11.5 years.
3. Calculate the NPV: The NPV (Net Present Value) takes into account the time value of money by discounting future cash flows back to the present. To calculate the NPV, multiply each cash flow by the discount factor and subtract the initial investment.
In this case, the discount factor for an annuity with a required rate of return of 14% and a useful life of 20 years is 6.623.
NPV = (6.623 x $4 million) - $46 million
= $26.492 million - $46 million
= -$19.508 million
So, the NPV for this project is -$19.508 million.
For question 2: To determine the NPV and payback of the project with the additional savings suggested by production and marketing, we need to add the additional savings to the original savings.
NPV = (6.623 x ($4 million + $1 million + $2.5 million)) - $46 million
= (6.623 x $7.5 million) - $46 million
= $49.6725 million - $46 million
= $3.6725 million
So, the NPV for this project with the additional savings is $3.6725 million.
For question 3: To determine the NPV and payback of the project using all the information from question 2, with the amount of the investment at the higher estimate of $50 million, we use the same steps as before.
Payback = $50 million / $7.5 million = 6.67 years
NPV = (6.623 x ($7.5 million x 6.67)) - $50 million
= (6.623 x $50 million) - $50 million
= $331.316 million - $50 million
= $281.316 million
So, the NPV for this project with the higher investment amount is $281.316 million.
For question 4:
a. Based on the data from (1)-(3) above, you should provide a recommendation regarding the investment. In this case, the NPV is negative (-$19.508 million) for the original savings and investment estimates, and it only becomes positive ($3.6725 million) with the additional savings. This suggests that the investment may not yield favorable returns and may not be financially viable.
b. Two other ways to deal with risk and uncertainty regarding this project could be:
1. Sensitivity analysis: By conducting sensitivity analysis, you can determine how changes in key variables (such as discount rate, initial investment, or cash flows) affect the project's NPV. This can help assess the project's sensitivity to different scenarios and provide insights into the level of risk involved.
2. Scenario analysis: Scenario analysis involves analyzing different plausible scenarios or outcomes based on varying assumptions. This allows you to assess the project's viability under different circumstances and make more informed decisions based on different potential outcomes.
c. The two most important qualitative issues related to this project could be:
1. Market competition and customer demand: Assessing the market competition and customer demand is crucial because the decision relies on capturing market share from competitors. If the market is declining or the customers have different preferences or alternative options, the project's success and ability to generate returns may be compromised.
2. Technological obsolescence and future adaptability: Evaluating the potential obsolescence of the proposed automation technology and the company's ability to adapt to future technological advancements is essential. If the technology becomes outdated quickly or if the company is unable to adapt to future changes, the investment may become obsolete, leading to potential losses.