Determine the proposal’s appropriateness and economic viability. For all scenarios, assume spending occurs on the first day of each year and benefits or savings occurs on the last day. Assume the discount rate or weighted average cost of capital is 10%. Ignore taxes and depreciation.
New Factory
A company wants to build a new factory for increased capacity. Using the net present value (NPV) method of capital budgeting, determine the proposal’s appropriateness and economic viability with the following information:
• Building a new factory will increase capacity by 30%.
• The current capacity is $10 million of sales with a 5% profit margin.
• The factory costs $10 million to build.
• The new capacity will meet the company’s needs for 10 years.
• The factory is worth $14 million over 10 years
To determine the proposal's appropriateness and economic viability, we will calculate the net present value (NPV) using the given information and a discount rate of 10%.
Step 1: Calculate the annual profit from the current capacity:
Current capacity sales = $10 million
Profit margin = 5%
Annual profit = Current capacity sales * Profit margin = $10 million * 5% = $500,000
Step 2: Calculate the additional annual profit from the new factory:
Additional sales from new capacity = 30% of current capacity sales = 30% * $10 million = $3 million
Additional annual profit = Additional sales * Profit margin = $3 million * 5% = $150,000
Step 3: Calculate the total annual profit (current + additional):
Total annual profit = Annual profit from current capacity + Additional annual profit = $500,000 + $150,000 = $650,000
Step 4: Calculate the total present value of the additional annual profit over 10 years:
Total present value = Total annual profit * Present value factor
Present value factor = 1 / (1 + Discount rate)^Number of years
Present value factor = 1 / (1 + 0.10)^10 = 1 / 1.10^10 = 1 / 2.5937 = 0.3855
Total present value = $650,000 * 0.3855 = $250,575
Step 5: Calculate the NPV by subtracting the initial cost of building the factory:
NPV = Total present value - Cost to build the factory
NPV = $250,575 - $10 million = -$9,749,425
Step 6: Evaluate the NPV:
If the NPV is positive, the proposal is appropriate and economically viable. If the NPV is negative, the proposal is not appropriate and economically viable.
In this case, the NPV is -$9,749,425, which is negative. Therefore, the proposal for building the new factory is not appropriate and economically viable.
To determine the proposal's appropriateness and economic viability using the net present value (NPV) method, we need to calculate the net present value of the project.
Here's how you can do it:
Step 1: Calculate the initial investment:
The initial investment is the cost of building the new factory, which is $10 million.
Step 2: Calculate the annual cash inflows:
To calculate the cash inflows, we need to determine the additional sales generated by the new capacity and the corresponding profit margin.
Additional sales = 30% of current capacity = 30% of $10 million = $3 million
Profit margin on additional sales = 5%
Annual profit from new capacity = Additional sales * Profit margin = $3 million * 5% = $150,000
Step 3: Calculate the terminal value:
The terminal value represents the total worth of the factory over the project's duration. In this case, it is $14 million over 10 years.
Step 4: Calculate the discounted cash flows:
Discounted cash flows take into account the time value of money, which means future cash flows are worth less than present cash flows. We use the discount rate of 10% to calculate the present value of the cash flows.
Present value = Cash flow / (1 + discount rate)^n
Where n is the year in which the cash flow occurs.
For each year, calculate the present value of the annual profit:
Year 1: $150,000 / (1 + 0.10)^1 = $136,364
Year 2: $150,000 / (1 + 0.10)^2 = $124,041
...
Year 10: $150,000 / (1 + 0.10)^10 = $59,234
To calculate the present value of the terminal value, we use the same formula:
Terminal value: $14 million / (1 + 0.10)^10 = $5,357,142
Step 5: Calculate the NPV:
The NPV is the sum of all discounted cash flows minus the initial investment.
NPV = Sum of present values - Initial investment
= ($136,364 + $124,041 + ... + $59,234 + $5,357,142) - $10 million
If the NPV is positive, the proposal is considered economically viable. If the NPV is negative, the proposal may not be economically viable.
Now, you can calculate the NPV using the above steps.