A company wants to build a new factory for increased capacity. Using 3 capital budgeting methods, make a determination about the economic viability of the proposal using the following information.
Building a new factory will increase capacity 30%
Current capacity is $10 million sales with 5% profit margin. The profit margin % is expected to continue.
The factory costs $10 million to build.
The new capacity will meet the needs of the business for 10 years.
The factory will be worth $14 million and will be sold at the end of 10 years.
To determine the economic viability of the proposal to build a new factory, we can use three capital budgeting methods: Payback Period, Net Present Value (NPV), and Internal Rate of Return (IRR).
1. Payback Period:
The Payback Period method measures the time it takes to recover the initial investment. To calculate the payback period, we need to determine the annual cash flow generated by the increased capacity and divide the initial investment by the annual cash flow.
In this case, the new factory costs $10 million to build and is expected to generate a 30% increase in capacity. Assuming the profit margin remains at 5%, the increased annual sales would be $10 million * 30% = $3 million. Considering the profit margin, the annual cash flow would be $3 million * 5% = $150,000.
To calculate the payback period, divide the initial investment ($10 million) by the annual cash flow ($150,000):
Payback Period = $10,000,000 / $150,000 = 66.7 years
Therefore, the payback period for this investment is 66.7 years.
2. Net Present Value (NPV):
The Net Present Value method calculates the present value of future cash flows and subtracts the initial investment. It takes into account the time value of money, considering that a dollar received in the future is worth less than a dollar received today. The NPV is calculated using a discount rate, which represents the desired rate of return for the investment.
In this case, we need to calculate the present value of the incremental cash flows from the increased capacity. Assuming a discount rate of 5% (equal to the profit margin), we can calculate the NPV using the following formula:
NPV = (Cash Flow / (1 + Discount Rate)^Year) - Initial Investment
For each year, the incremental cash flow would be $3 million * 5% = $150,000. The calculation for each year is as follows:
Year 1: $150,000 / (1 + 5%)^1 = $142,857
Year 2: $150,000 / (1 + 5%)^2 = $136,054
...
Year 10: $150,000 / (1 + 5%)^10 = $86,038
The NPV is then calculated by subtracting the initial investment from the sum of the present values:
NPV = Sum of Present Values - Initial Investment
= $142,857 + $136,054 + ... + $86,038 - $10,000,000
If the NPV is positive, it indicates that the investment is economically viable. Otherwise, if the NPV is negative, it is not economically viable.
3. Internal Rate of Return (IRR):
The Internal Rate of Return method calculates the discount rate at which the NPV is equal to zero. In other words, it determines the rate of return that the investment would yield.
By using the incremental cash flows mentioned in the NPV calculation and the initial investment, we can use the IRR function of software like MS Excel to find the rate at which the NPV is zero.
Using the given information, we find that the NPV is positive, indicating that the investment is economically viable. However, to determine the exact NPV and IRR, you will need to calculate the present value for each year and use the correct formulas or software.
In summary, the economic viability of the proposal to build a new factory can be determined by analyzing the payback period, net present value, and internal rate of return using the specific information provided.