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 using the net present value (NPV) method of capital budgeting, we need to calculate the NPV of the project. NPV helps us evaluate the profitability of an investment by comparing the present value of cash inflows and outflows.
Here are the steps to calculate the NPV:
Step 1: Calculate the initial investment cost:
The initial investment cost is the cost to build the new factory, which in this case is $10 million.
Step 2: Calculate the cash inflows:
The cash inflows are the additional profits generated by the increased capacity. To calculate this, we need to determine the annual increase in sales and calculate the profit margin.
Annual increase in sales = 30% of the current capacity = 30% * $10 million = $3 million
Profit margin = 5% of sales = 5% * $3 million = $150,000
Cash inflows for each year over the 10-year period = $150,000
Step 3: Determine the discount rate:
The discount rate is used to calculate the present value of future cash flows. It represents the minimum required return on investment. Let's assume a discount rate of 10% for this example.
Step 4: Calculate the present value of cash inflows:
To calculate the present value of cash inflows, we need to discount each year's cash inflow. The formula for calculating the present value is:
Present Value = Cash inflow / (1 + discount rate)^year
For this example, we will calculate the present value for each year (1 to 10) and sum them up.
Present value of cash inflows = ($150,000 / (1 + 0.1)^1) + ($150,000 / (1 + 0.1)^2) + ... + ($150,000 / (1 + 0.1)^10)
Step 5: Calculate the net present value (NPV):
The NPV is the difference between the present value of cash inflows and the initial investment cost.
NPV = Present value of cash inflows - Initial investment cost
If the NPV is positive, it means the project is financially viable and potentially profitable. If the NPV is negative, it indicates that the project may not be economically sound.
By following these steps and plugging in the numbers from the given information, you should be able to calculate the NPV and determine the proposal's appropriateness and economic viability.