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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 The project is expected to generate revenues of £30,000 for each of the next five years after which it would be withdrawn from the market.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.

6. 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.)
7. 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.
8. 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