ABC Ltd is engaged in the manufacture of pharmaceuticals.

The company was

established in 2009 and has registered a steady growth in sales since then.
Presently, the company manufactures 16 products and has an annual turnover of
$2200 million. The company is considering the manufacture of a new antibiotic
preparation, Cowin, for which the following information has been gathered.

1. Cowin is expected to have a product life cycle of five years and thereafter it
would be withdrawn from the market. The sales from this preparation are
expected to be as follows:

Year Sales (in million $)

1 100

2 150

3 200

4 150

5 100

1. The capital equipment required for manufacturing Cowin is $ 100 million and it
will be depreciated at the rate of 25 % per year as per the SLM method for tax
purposes. The expected net salvage value after 5 years is $ 20 million.
2. The working capital requirement for the project is expected to be 20 % of
sales. At the end of 5 years, working capital is expected to be liquidated at
par, barring an estimated loss of $ 5 million on account of bad debt. The bad
debt loss will be a tax-deductible expense.
3. The accountant of the firm has provided the following cost estimates for
Cowin:

Raw material cost : 30 % of sales

Variable labour cost : 20 % of sales

Fixed annual operating and maintenance cost : $ 5 million

Overhead allocation (excluding depreciation,

Maintenance and interest ) : 10 % of sales

While the project is charged on an overhead allocation, it is not likely to have any
effect on overhead expenses as such.

1. The manufacturer of Cowin would also require some of the common facilities
of the firm. The use of these facilities would call for a reduction in the
 production of other pharmaceutical preparations of the firm. This would entail
a reduction of $ 15 million in contribution margin per year.
2. The tax rate applicable to the firm is 40 %.

Q1 Make a cash flow statement for the period of the project.

Q2 Calculate the Pay Back period, NPV @ 15%, and IRR of the project.

Q3. Highlight some of the shortcomings of IRR, and how can they be overcome.

Q1. Cash flow statement for the period of the project:

To know about the cash flow statement of the period of the statement

The following table is to know about the cash flow statement of the period of the
project
Year 0 1 2 3 4 5
Sales - 100 150 200 150 100
Raw
material - -30 -45 -60 -45 -30
cost
Variable
- -20 -30 -40 -30 -20
labor cost
Contributio
- 50 75 100 75 50
n margin
Fixed
operating - -5 -5 -5 -5 -5
cost
Overhead
- -10 -15 -20 -15 -10
allocation
EBITDA - 35 55 75 55 35
Depreciatio
- -25 -25 -25 -25 -25
n
EBIT - 10 30 50 30 10
Taxes(40%
- -4 -12 -20 -12 -
)
Net income -PAT 6 18 30 18 6
Add back
- 25 25 25 25 25
depriciation
Cashflow
before
-100 31 43 55 43 31
working
capital
Increase in - -20 -30 -40 -30 -5
working
capital
Capital
expenditure -100 - - - - 20
s
Cash flow -100 11 13 15 13 46

The payback period is the length of time it takes for the initial investment to be
recouped.
Payback period = 3 years + (100-55)/55 * 1 year = 3.91 years
To calculate NPV, we need to discount the cash flows at a given rate of return. Using
a discount rate of 15%, we get:

NPV = -100 + 11/(1+0.15) + 13/(1+0.15)^2 + 15/(1+0.15)^3 + 13/(1+0.15)^4 +

46/(1+0.15)^5 = $9.15 million
The IRR is the rate of return that makes the NPV equal to zero. Using a financial
calculator or Excel, we can find that the IRR of the project is approximately 17.5%.

Q3. One shortcoming of IRR is that it assumes that cash flows are reinvested at the
same rate as the IRR, which may not always be realistic. Another shortcoming is that
it does not take into account the scale of the investment or the size of the cash flows,
which can be problematic when comparing projects with different cash flow profiles.
To overcome these shortcomings, one approach is to use the modified internal rate
of return (MIRR), which assumes that cash flows are reinvested at a rate equal to the
cost of capital. Another approach is to use the profitability index (PI), which
calculates the ratio of the present value of future cash flows to the initial investment.
The PI provides a relative measure of the profitability of a project and can be useful
when comparing projects with different cash flow profiles.


 Q:You are considering a new product. Machinery and equipment will cost
$60,000 if bought today and it will be depreciated straight line to zero over the
next three years. In addition, you will require a working capital of $15,000
immediately to get the product to the market next year. The new product is
expected to generate revenue of $100,000 per year for the next 3 years.
Project operating costs will be $40,000 per year. At the end of the three years,
you will recover your initial working capital. Taxes will be 40% and the
project's risk level is specified to be high and thus you assign a required return
of 11% to it.

Calculate:

1. Payback period
2. NPV
3. IRR

Ans- he calculation for initial investment:

initial investment = Cost of machine + working capital

=60000 + 15000
=75000

Depreciation calculation
=Cost of machine /life of the asset
=60000 / 3
=20000

We are given:
Annual revenue = 100000
Operating costs = 40000

Cash flow calculation:

Profit before tax = Annual revenue - annual costs - depreciation

=100000 - 40000 - 20000
=40000

Tax calculation
=tax rate * profit before tax
=40%×40,000=16,000
Profit after tax = profit before tax - tax
=40000 - 16000
=24000

Finally, depreciation is added back to get the final cash flows:

=Profit after tax + depreciation

=24000 + 20000
=44000

Cash flow in year 0 (initial investment) = 75000

Cash flow in year 1 and year 2 = 44000
Cash flow in year 3 = Cash flow in year 1 + working capital
=44000 + 15000
=59000
Explanation:
Working capital is added in last year of project to make recovery of working capital.
So, now we have our cash flows, we can make further calculations.

A B C D E F G
1 A B C D E F
 PV Factor Cumulative cash
2 1 Year Project Cash Flow PV Factor Present value
formula flows
3 2 0 -75000.00 1 =1/(1+11%)^0 -75000.00 -75000.00
4 3 1 44000 0.9009009 =1/(1+11%)^1 39639.64 -31000.00
5 4 2 44000 0.8116224 =1/(1+11%)^2 35711.39 13000.00
6 5 3 59000 0.7311914 =1/(1+11%)^3 43140.29 72000.00
7 6
8
9
1 Payback
1.70
0 period
1
NPV 43491.32
1
1
IRR 40.
2
1. Payback period

payback period formula:

payback period = Year when the cumulative cash flow was last negative-(value of
cumulative cash flow which was last negative/ Subsequent next year cash flow
value)

=1−(−31,00044,000)=1.70
Payback period = 1.70 years
2.)The formula for NPV calculation:

NPV = Sum of the present value of cash flows - initial investment

PV Factor formula:
=1/(1+Rate)^number of periods

PV Factor is multiplied by the cash flow to get the present value of that year.
. IRR will be calculated by using the Excel IRR function.
Just type =IRR in any cell in Excel to start the function.

Formula:
=IRR(values...)

2.)So, the calculation of the present value is shown in the above table.

NPV = (39639.64+35711.39+43140.29) - 75000

=43491.32

IRR calculation:

=IRR(B2:B5)
=40.38%
Sketchers Inc., is considering the purchase of a $500,000 computer with an

economic life of five years. The computer will be fully depreciated over five years
using
the straight-line method. The market value of the computer will be $100,000 after five

years. The computer will replace five office employees whose combined annual
salaries

are $150,000. However, the electricity charges for running the computer will be
incurred

at $15 per unit consumption basis. The 1st year consumption is expected to be 2000
units.

After that company aims to keep a check will be able to reduce consumption by 200
unit

on reducing balance basis until the machine was sold. The machine will also
immediately

lower the firm’s required net working capital by $100,000. This amount of net working

capital will need to be replaced once the machine is sold. The corporate tax rate is
34

percent.

a) Is it worthwhile to buy the computer if the appropriate discount rate is 12 percent?

b) Explain project acceptance rules for Payback and IRR techniques. Also give
points why

payback period is not a preferred method.

Expert Answer

This solution was written by a subject matter expert. It's designed to help students like you
learn core concepts.

Step-by-step

1st step
All steps
Answer only
Step 1/3

Explanation:
To determine whether it is worthwhile to buy the computer, we need to calculate Net
Present Value. NPV = -Initial Cost + PV of Future Cash Flows
Outflow Summary :
Initial Cost i.e. Cash outflow at the time of purchase of Computer is $500,000

Outflow of Cash on account of electricity charges (in 1st year) = $30000 (2000*$15)

Outflow of Cash on account of electricity charges from 2nd year till the computer is
sold, = $27000 (1800*$15)
Step 2/3
Inflow Summary

Annual Saving of Salaries = $150,000

Salvage value of Computer at the end of 5th year = $100,000

Annual Net Working Capital Reduction = $100,000

Explanation:
All the inflow to be brought into present value.

Step 3/3
Payback period: The payback period is the time it takes for the cash inflows from a
project to equal the initial investment. A project is accepted if its payback period is
less than a pre-determined cutoff period. For example, if the cutoff period is three
years, a project with a payback period of two years is accepted, while a project with
a payback period of four years is rejected.

Internal rate of return: The internal rate of return is the discount rate that makes the
net present value of the project equal to zero. A project is accepted if its internal rate
of return is greater than the required rate of return, or the cost of capital.

Explanation:
Payback period does not take into consideration the time value of money.

Final answer
Solution to Question no. a

a) To determine if it's worthwhile to buy the computer for Skechers Inc., we need to
calculate the net present value (NPV) of the project, which is the present value of all
future cash flows associated with the project minus the initial investment.

The initial investment is $500,000, and the market value of the computer after five
years is $100,000, so the depreciation expense over the life of the computer is
$80,000 per year ($500,000 - $100,000 / 5). The annual cost savings from replacing
the five office employees is $150,000 per year. The electricity charges for running
the computer in the first year are $30,000 (2,000 units x $15 per unit), and these
charges will decrease by $200 per year. The net working capital will decrease by
$100,000 initially, and this amount will need to be replaced when the computer is
sold.

Using a discount rate of 12 percent, we can calculate the NPV of the project as
follows:
Year 0: -$500,000

Year 1: $70,000 = $150,000 - $80,000 - $30,000 - $10,000 ($100,000 / (1+12%)^1)

Year 2: $81,600 = $150,000 - $80,000 - $29800 - $9,600 ($100,000 / (1+12%)^2)

Year 3: $93,552 = $150,000 - $80,000 - $29,600 - $8,848 ($100,000 / (1+12%)^3)

Year 4: $105,870 = $150,000 - $80,000 - $29,400 - $7,730 ($100,000 / (1+12%)^4)

Year 5: $114,707 = $150,000 - $80,000 - $29,200 - $6,093 ($100,000 / (1+12%)^5) +

$100,000

NPV = -$500,000 + $70,000/(1+12%) + $81,600/(1+12%)^2 + $93,552/(1+12%)^3 +

$105,870/(1+12%)^4 + $114,707/(1+12%)^5

NPV = $1,490.11

Since the NPV is positive, it is worthwhile to buy the computer at a discount rate of
12 percent.