Solution to Unit 7 Problem

1) Production in units/year
Production = No of hours/day X capacity per hour X capacity X No. of effective
Utilization working days/year

Year No of hours Capacity Capacity No of effective Estimated

per day per hour utilization working days/year production (units)
1 8 100 80% 300 192,000
2 8 100 80% 300 192,000
3 8 100 80% 300 240,000
4 8 100 80% 300 240,000
5 8 100 80% 300 240,000

2. Raw materials Requirements

Requirements = Estimated production X materials required per unit of output
Year
1 2 3 4 5
Production 192,000 192,000 240,000 240,000 240,000
Material x (2kg/unit) 384,000 384,000 480,000 480,000 480,000
Material y (1kg/unit) 192,000 192,000 240,000 240,000 240,000

3. Cost of raw materials and packaging

Raw material cost = Requirements in units X Cost/unit
Packaging cost = Estimated production (units) X Packaging cost per unit of output
The cost of raw materials and packaging is computed as follows:

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4. Annual Revenue of the Project
Annual sales = Sales in units x selling price per unit
Year 1 = 192,000 x 22 = 4,224,000
Year 2 = 192,000 x 22 = 4,224,000
Year 3 = 240,000 x 22 = 5,280,000
Year 4 = 240,000 x 22 = 5,280,000
Year 5 = 240,000 x 22 = 5,280,000
5. Annual total production costs
Total production costs = Direct materials used + Direct labour cost + Factory overhead costs
In the question under consideration, factory overhead is composed of electricity and water
charges (variable costs), fixed factory overhead, and depreciation (60% of annual depreciation
of Br. 250,000). Accordingly, factory overhead costs are computed below:
Year
1 2 3 4 5
Depreciation (60%) 150,000 150,000 150,000 150,000 150,000
Electricity and water* 197,000 197,000 245,000 245,000 245,000
Other fixed factory overhead 768,000 806,400 846,720 889,056 933,509
Total factory overhead 1,115,000 1,153,400 1,241,720 1,284,056 1,328,509

* Electricity and water charges = (Estimated production x 1) + 5000

Then direct labor cost can also be calculated as follows:
Year 1 = 614,400 Year 4 = 626,688 x 1.02 = 639,222
2 = 614,400 Year 5 = 639,222 x 1.02 = 652,006
3 = 614,400 x 1.02 = 626,688

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Finally, total production costs are computed below:
Year Raw material Direct labour Factory Total
costs costs overhead production
costs costs
1 1,632,000 614,400 1,115,000 3,361,400
2 1,632,000 614,400 1,153,400 3,399,800
3 2,040,000 626,688 1,241,720 3,908,408
4 2,040,000 639,222 1,284,056 3,963,278
5 2,040,000 652,006 1,328,509 4,020,515
6. Loan Repayment Schedule
Initial investment = Gross investments + Increase in NWC
= 1,250,000 + 300,000 = 1,550,000
Amount of loan = 1,550,000 x 50% = 775,000 (50% of initial investment is financed
by debt)
Annual loan repayment (A):
 1 
1 
(1  i ) n
PVA = A 
 i 
 
 
where;
PVA = Present value of annuity
A = Periodic payment
i = The required rate of return
n = No of periods to maturity
 1 
1 
(1  0.10) 3
775,000 = A 
 0.10 
 
 
775,000 = A (2.487)
775,000
A=
2.487
= 311,620

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Loan repayment schedule
Year Amount Unpaid balance Interest Principal unpaid
Installment at beg. of year Repayment balance at
End of year
1 __ 755,000 __ __ 775,000
2 311,620 755,000 77,500 234,120 540,880
3 311,620 540,880 54,088 257,532 283,348
4 311,620 283,348 28,272 283,348 __

7. Projected Income Statement

Since there are no beginning and ending finished goods inventory, total production costs is
equal to cost of goods sold. Operating expenses are computed as follows:
Year
1 2 3 4 5
Depreciation 100,000 100,000 100,000 100,000 100,000
Selling and administrative
expenses 450,000 450,000 460,000 470,000 480,000
Total factory overhead 550,000 550,000 560,000 570,000 580,000

Projected Income Statement for five years:

Year
1 2 3 4 5
Sales 4, 224,000 4,224,000 5,280,000 5,280,000 5,280,000
Cost of goods sold 3,361,400 3,399,800 3,908,408 3,963,278 4,020,515
Gross profit 862,600 824,200 1,371,592 1,316,722 1,259,485
Operating expenses 550,000 550,000 560,000 570,000 580,000
Operating Income 312,600 274,200 811,592 746,722 679,485
Interest expense - 77,500 54,088 28,272 -
Income before tax 312,600 196,700 757,504 718,450 679,485
Tax (40%) - - 303,002 287,380 271,794
Net income 312,600 196,700 454,502 431,070 407,691

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8. Net cash flows:
Year
1 2 3 4 5
Net Income 312,600 196,700 454,502 431,070 407,691
Add: Depreciation 100,000 100,000 100,000 100,000 100,000
Recovery in NWC - - - - 300,000
Salvage proceeds - - - - 200,000
Interest - 46500 a 32453 b 16963 c -

Net cash flows 412,600 343200 586955 548033 1007691

a) Interest (1 – Tax rate) = 77500(1-0.40) = 46500

b) 54088 (1-0.40) = 32453
c) 28272 (1 – 0.40) = 16963

9. Project evaluation
a) Payback period (PBP)
Initial investment = 1,250,000 + 300,000 = 1,550,000
207245
PBP = 3 years + = 3.38years
548033
b) ARR =
312,600  196,700  454,502  431,070  409,691
Average Net income =
5
1,802,563
=
5
= 306,513
1,550,000  220,000
Average investment =
2
= 885,000
360,513
ARR = = 41%
885,000

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c) Net present value
Year NCF Discount Factor Present value
1 412,600 0.926 382,068
2 343200 0.857 294122
3 586955 0.794 466042
4 548033 0.735 402804
5 1007691 0.681 686238
Present value of NCF 2,231,274
Less: Initial Investment 1,550,000
NPV +681274

d) IRR = 21.03%
e) Benefit-Cost ratio (Profitability index)
PV of NCF
Benefit-Cost ratio =
Initial Investment
2231274
=
1,550,000
= 1.44