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 appropriateness and economic viability of the proposal using the net present value (NPV) method, we need to calculate the NPV of the project. Here are the steps to do that:
Step 1: Calculate the annual additional profit from the increased capacity.
Current Sales: $10 million
Profit Margin: 5%
Additional Sales from Increased Capacity: 30% of $10 million = $3 million
Additional Profit from Increased Sales: 5% profit margin * $3 million = $150,000
Step 2: Determine the net cash inflows for each year.
The new factory's cost is $10 million, but since it is a one-time investment, we don't consider it as a cash inflow. Therefore, the net cash inflow for each year will be the additional profit from the increased capacity, which is $150,000.
Step 3: Determine the discount rate.
The discount rate represents the company's required rate of return or the cost of capital. Let's assume a discount rate of 8%.
Step 4: Calculate the present value for each year's net cash inflow.
Using the discount rate of 8%, we can calculate the present value (PV) for each year's net cash inflow using the following formula:
PV = Net Cash Inflow / (1 + Discount Rate)^Number of Years
Year 1: PV = $150,000 / (1 + 0.08)^1 = $138,889
Year 2: PV = $150,000 / (1 + 0.08)^2 = $128,453
Year 3: PV = $150,000 / (1 + 0.08)^3 = $118,976
...
Year 10: PV = $150,000 / (1 + 0.08)^10 = $63,388
Step 5: Calculate the NPV.
To calculate the NPV, we sum up the present values of all the net cash inflows and subtract the initial investment cost.
NPV = Sum of PV - Initial Investment Cost
NPV = ($138,889 + $128,453 + $118,976 + ... + $63,388) - $10 million
If the NPV is positive, the proposal is appropriate and economically viable. If the NPV is negative, the proposal may not be acceptable.
Please note that since we don't have the values for each year's net cash inflows, I have provided a general framework to calculate the NPV based on the given information.
To determine the appropriateness and economic viability of the new factory proposal using the net present value (NPV) method of capital budgeting, we need to calculate the net present value of the project.
1. Calculate the increased sales revenue from the new factory:
Current capacity = $10 million of sales
30% increase in capacity = 0.3 * $10 million = $3 million
New sales revenue = $10 million + $3 million = $13 million
2. Calculate the annual profit from the increased sales revenue:
Profit margin = 5%
Annual profit = 5% * $13 million = $0.65 million
3. Calculate the total profit over the 10-year period:
Total profit = $0.65 million * 10 years = $6.5 million
4. Calculate the net present value (NPV) of the project:
NPV = Present value of future cash flows - Initial investment
Initial investment = $10 million (cost to build the factory)
Present value of future cash flows = $6.5 million (total profit over 10 years) + $14 million (resale value of the factory)
Present value of future cash flows = $20.5 million
NPV = $20.5 million - $10 million = $10.5 million
Based on the calculation, the net present value (NPV) of the project is $10.5 million. A positive NPV indicates that the proposal is appropriate and economically viable. This means that building the new factory is expected to generate positive returns and increase the value of the company.