Download Finance - Tutorial 5 (40) and more Study Guides, Projects, Research Finance in PDF only on Docsity!
Capital Budgeting Q1. Blackwood Plastics
M.Sc. Finance, M.Sc. Investment
and Finance, M.Sc. International
Banking and Finance and M.Sc.
International Accounting and
Finance 2008/
Finance I: Tutorial 4 SOLUTIONS
Blackwood Plastics is considering an investment in a new product and seeks your advice on the profitability of the venture. The project will require an investment of £20,000 in a new machine and the use of some of the firm’s existing equipment. This equipment has a book value of £10,000 but is fully depreciated for tax purposes. The alternative use of equipment would be its sale for scrap and this could only be expected to yield £500. As the firm has spare capacity in its existing facilities the project would require no investment in new buildings. The project is expected to generate revenues of £30,000 for each of the next five years after which it would be withdrawn from the market. Variable costs are expected to be £18,000 per annum and fixed costs of £2,000 per annum. The machinery purchases for this project would be sold at the end of the five years for about £2,000. An investment in working capital of about £3,000 would also be necessary. The new machine would be depreciated for tax purposes on a straight‐line basis over five years. a) If the required rate of return is 10 per cent and the tax rate is 40 per cent, is this a worthwhile project?
Question 2 Dulais Ltd
a) The finance director of Dulais Ltd has been asked to evaluate a proposed investment in the manufacture of
special purpose valves.
It would require an initial outlay of £1.2 million on machinery and this is expected to have a working life of
five years. It should be
possible to sell the machinery for about £100,000 at the end of this period to a company specialising in
reconditioning this type of machinery. For tax purposes it would have to be depreciated on a straight‐line
basis over five years. The project is expected to generate sales of 80,000 units in the first year at a price
of £13 per unit, and it is anticipated that the volume of sales would grow by
20 per cent in year two. From year two onwards sales are expected to remain at 96,000 units. The
company would hold stocks at the start of each period equivalent to 15 per cent of the number of units
expected to be sold in that period. Direct costs
are expected to be £6 per unit and fixed costs, excluding depreciation, are likely to be about £100,000 per
annum. In addition the project would be allocated an overhead charge of 10 per cent of sales revenue to
cover head office expenses and other general costs of running the company. The company has no capacity
available to locate the investment and it would be necessary to rent space in a nearby factory for £30,
per annum. The product has already incurred development costs of £160,000. Corporation tax is payable
(in the same year) on taxable profits at the rate of 30 per cent. The company requires a rate of return of
14 per cent. Undertake an appraisal of the proposed investment for the finance director. Specify and
comment on your assumptions.
b) Explain the treatment of working capital in your analysis.
c) Explain and discuss how overheads stemming from head office expenses should be treated in the
evaluation of investment proposals.
d) Explain briefly what is meant by sensitivity analysis and how it could be used in the evaluation of Dulais’s
proposed investment.
- The overhead allocation does not appear to represent an incremental cost incurred as a result of undertaking the project and will be left out of the analysis. (It is assumed that the underlying costs will be incurred whether or not the company decides to proceed with the investment and as a result are irrelevant for decision taking purposes in this context.)
- The rent of the factory is recognized as a cash outflow (cash flow statement) and an expense (profit and loss account) of £30,000: this is cost that will be incurred by proceeding with the investment.
- The development costs of £160,000 have already been incurred (a sunk cost) and are not (directly) relevant for the decision to be taken.
Profit And Loss Account
Unit Sales
Price 13 13 13 13 13 Unit Cost 6 6 6 6 6
Revenues
Variable Costs ‐ 480000 ‐ 576000 ‐ 576000 ‐ 576000 ‐ 576000 Fixed Costs ‐ 100000 ‐ 100000 ‐ 100000 ‐ 100000 ‐ 100000 Overheads R&D Rental costs ‐ 30000 ‐ 30000 ‐ 30000 ‐ 30000 ‐ 30000 Depreciation (CA) ‐ 240000 ‐ 240000 ‐ 240000 ‐ 240000 ‐ 240000
Overheads
Working Capital 16 Stocks
Taxation 17 Pre tax cash flow 18 Tax (delay one year) 19 After tax cash flow
Discounting 20 Discount factor 10 per cent 21 Discount cash flow
Net present value at 10 per cent
PROFIT and LOSS ACCOUNT
1
CASH FLOW STATEMENT Sales
- Variable Costs ‐ 480000 ‐ 576000 ‐ 576000 ‐ 576000 ‐
- Fixed Costs ‐ 100000 ‐ 100000 ‐ 100000 ‐ 100000 ‐
- Rental costs ‐ 30000 ‐ 30000 ‐ 30000 ‐ 30000 ‐ R&D
- Working Capital ‐ 72000 ‐
- Tax 0 ‐ 57000 ‐ 90600 ‐ 90600 ‐ 90600 ‐
- NCF ‐
- PVF 1.
- Present Values ‐
- NPV
- 0.8772 0.7695 0.6750 0.5921 0.
- 314561 347337.6
- 1 Sales revenue 600
- 2 Variable costs ‐ 200 ‐ 500 ‐ 800 ‐ 700 ‐
- 3 Contribution
- 4 Fixed costs ‐ 400 ‐ 400 ‐ 400 ‐ 400 ‐
- 5 Gross margin
- 6 Depreciation – building ‐ 152 ‐ 32 ‐ 32 ‐ 32 ‐
- 7 Depreciation – plant ‐ 240 ‐ 240 ‐ 240 ‐ 240 ‐
- 8 Research and development ‐ 150 ‐
- 9 Profit ‐ 150 ‐ 70 ‐
- 10 Tax at 45 per cent 52.5 24.5 137. 2 ‐ 114.8 ‐ 324.8 ‐ 254.8 ‐ 79. - 600 revenue
- 2 Variable costs ‐ 200 ‐ 500 ‐ 800 ‐ 700 ‐
- 3 Contribution
- 4 Fixed costs ‐ 400 ‐ 400 ‐ 400 ‐ 400 ‐
- 5 Gross margin
- 6 R & D ‐ 150 ‐
- 7 Building ‐
- 8 Plant ‐
- 9 Cash grant
- 75 25 62.5