MME40001 Engineering Management 2 Topic: Investment Decision Analysis

Tutorial 4: Capital or Project Investment Decisions

Problem 1: Spark Electrical Company is planning to introduce a toaster-grill to its line of small home appliances.
Annual sales of the toaster-grill are estimated at 5,000 units at a price of $69, variable cost per unit of $39,
manufacturing costs (other than depreciation) at $30,000 annually, and incremental selling and general expenses
relating to the grillers at $35,000 annually.
To build toaster-grills the company must invest $200,000 in moulds, patterns and special equipment. Since
the company expects to change the design of the toaster-grill every five years, this equipment will have five
years service life with no salvage value. Depreciation will be calculated on a straight-line basis. All revenue
and expenses other than depreciation will be received or paid in cash. The companys tax rate is 30 per cent.
a) Calculate the annual implications of the project for financial performance after tax.
b) Calculate the cash flow consequences of the project over the life of the first model.
c) Calculate
i. Accounting rate of return
ii. Payback
iii. Net present value assuming a 15 per cent discount rate

Problem 2: You are employed as the Costs Engineer of X Factor Ltd. The directors of X Factor are currently
considering two mutually exclusive investment projects, both concerning with the purchase of new plant. The
following data are available for each project.

Account data Project A ($) Project B ($)

Purchase of plant cost (immediate purchase) 75,000 55,000
Expected annual net profit (loss) before
depreciation
Year 1 38,000 12,000
Year 2 27,000 24,000
Year 3 16,000 36,000
Estimate residual value at the end of year 3 24,000 10,000

The firm required rate of return of 10% and employs the straight-line method of depreciation for all non-current assets
when calculating net profit. Neither project would increase the working capital of the firm. The firm has insufficient
funds to meet all capital expenditure requirements. The firm tax rate is 30%.
a. Calculate for each project:
i. The payback period
ii. The net present value
b. Which of the two investment projects you would recommend to the directors of X Factor? Justify your
answer.

Problem 3: The product development department of a Manufacturing company is contemplating renting a factory
building on a five-year lease from 1 January 2011, investing in some heavy machinery and using it to produce a new
product called Gadget.

Under the lease the business will pay $150,000 annually in advance on 1 January of each year. The heavy machinery
is expected to cost $250,000. This will be bought and paid for on 1 January 2011 and is expected to be scrapped (zero
proceeds) on 31 December 2015.

Each unit of Gadget is estimated to give rise to a variable labour cost of $200 and a variable material cost of $200.
Manufacture and sales of Gadget is expected to incur administrative costs of$100,000 each year.

Abstracted from Atrill, Mclaney, Harvey, and Jenner, Accounting An Introduction, 4e, 2009. Pearson. 1
Manufacture and sales of Gadget are expected to be as follows:
Year ending 31 December Year Units of Gadget
2011 200
2012 400
2013 500
2014 400
2015 100
The Gadget will be sold for an estimated $1,400 each.

Since there is no possibility of continuing the manufacturing of Gadget to be economically viable beyond a five-
year life, it has been decided to assess the new product over a five-year manufacturing and sales life.

The businesss accounting year end is 31 December each year. It has been decided, given the level of risk involved
with the project to use a discount rate of 10% a year.

a) Identify the annual net relevant cash flows and use this information to assess the project on a Net Present
Value (NPV) basis at 1 January 2011.

If they can bring down the administrative cost of manufacturing Gadget to$60,000 each year, then what impact does
it have on the decision based on NPV?

Problem 4: As a Project manager you are asked to evaluate the following investment opportunity. The company is
planning on introducing a new product that was under research and development for the past one year. Now the
project is mature enough to be test marketed. The new product can only be manufactured in dedicated hi-tech
machines to be purchased at a one-time cost of 275,000. Since the existing factory building is running at full capacity,
the new product has to be manufactured in a rented factory building. This rental agreement, for annual payment of
65,000 payable at the beginning of each year, will be recurring for the expected life of the project which is five years.

The marketing department has the following forecast for demand and sales price for the new product:

Reference Year Annual demand Sales Price

Year 1 3000 50
Year 2 6000 60
Year 3 8000 80
Year 4 6000 70
Year 5 4000 70

The variable material cost per unit is $18 and variable labour cost per unit is $12. The production department has
confirmed an additional annual fixed cost of $30,000 to be spent on security and maintenance.

It has been decided, given the level of risk involved with the project, to use a discount rate of 15% a year.

Required:
a) Deduce the relevant annual cash flows and use this information to assess the project on a net present value
basis at year 0.
b) Estimate the internal rate of return of the project.
c) Calculate the payback period for the investment.

Abstracted from Atrill, Mclaney, Harvey, and Jenner, Accounting An Introduction, 4e, 2009. Pearson. 2
Problem 5: Beacon Chemicals Ltd is considering the erection of a new plant to produce a chemical named X14. The
new plants capital cost is estimated at $100,000 and if its construction is approved now, the plant can be erected and
commence production by the end of 2012. $50,000 has already been spent on research and development work.
Estimates of revenues and costs arising from the operation of the new plant appear below:

2013 2014 2015 2016 2017

Sales price ($ per unit) 100 120 120 100 80
Sales volume (units) 800 1,000 1,200 1,000 800
Variable Costs ($ per unit) 50 50 40 30 40
Fixed costs ($000s) 30 30 30 30 30

If the new plant is erected, sales of some current products will be lost and this will result in a loss of contribution of
$15,000 per year over its life.
The accountant has informed you that the fixed costs include depreciation of $20,000 per annum on new
plant. A separate study shows that if the new plant was built, its construction would incur additional overheads,
excluding depreciation, of $3,000 per year, and it would require additional working capital of $30,000. For the
purposes of your initial calculation ignore taxation. (Hint: Treat the investment in working capital as a cash outflow at
the start of the project and an inflow at the end).

Required:
a) Deduce the relevant annual cash flows associated with building and operating the new plant.
b) Deduce the payback period.
c) Calculate the net present value using the discount rate of 10%

Problem 6: Bensen Corporation is considering three long-term capital investment proposals. Each investment has a
useful life of 5 years. Relevant data on each project are as follows.
Project Tic Project Tac Project Toe
Capital investment $160,000 $180,000 $200,000
Annual net income:
Year 1 13,000 18,000 27,000
2 13,000 17,000 22,000
3 13,000 16,000 16,000
4 13,000 12,000 13,000
5 13,000 9,000 12,000
Total $ 65,000 $ 72,000 $ 90,000
Depreciation is computed by the straight-line method with no salvage value. The companys cost of capital is 15%.

Instructions
(a) Compute the annual rate of return for each project. (Round to one decimal.)
(b) Compute the cash payback period for each project. (Round to two decimals.)
(c) Compute the net present value for each project. (Round to nearest dollar.)
(d) Rank the projects on each of the foregoing bases. Which project do you recommend?

Abstracted from Atrill, Mclaney, Harvey, and Jenner, Accounting An Introduction, 4e, 2009. Pearson. 3
Abstracted from Atrill, Mclaney, Harvey, and Jenner, Accounting An Introduction, 4e, 2009. Pearson. 4