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Case 1 - Capital Budeting

Case 1 involves an appraisal of a $5 million investment project by Hraxin Co that has an expected 4-year life. It will generate scrap value of $500,000 and faces uncertain future selling prices depending on economic conditions. Sensitivity analysis would help assess the risk of the project due to this uncertainty. Case 2 involves Argnil Co's appraisal of purchasing a new $1.5 million machine to replace an outdated one. It would have production of 400,000 units annually over 4 years, with fixed and variable costs. Using an NPV approach and the company's 11% cost of capital, the purchase appears financially acceptable. However, investment may be limited even with attractive opportunities due to financing

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119 views3 pages

Case 1 - Capital Budeting

Case 1 involves an appraisal of a $5 million investment project by Hraxin Co that has an expected 4-year life. It will generate scrap value of $500,000 and faces uncertain future selling prices depending on economic conditions. Sensitivity analysis would help assess the risk of the project due to this uncertainty. Case 2 involves Argnil Co's appraisal of purchasing a new $1.5 million machine to replace an outdated one. It would have production of 400,000 units annually over 4 years, with fixed and variable costs. Using an NPV approach and the company's 11% cost of capital, the purchase appears financially acceptable. However, investment may be limited even with attractive opportunities due to financing

Uploaded by

Pooja Khimani
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Case 1

Hraxin Co is appraising an investment project which has an expected life of four


years and which will not be repeated. The initial investment, payable at the start
of the first year of operation, is $5 million. Scrap value of $500,000 is expected to
arise at the end of four years. There is some uncertainty about what price can be
charged for the units produced by the investment project, as this is expected to
depend on the future state of the economy. The following forecast of selling
prices and their probabilities has been prepared: Future economic state Weak
Medium Strong

Probability of future economic state 35% 50% 15%

Selling price in current price terms $25 per unit $30 per unit $35 per unit T

hese selling prices are expected to be subject to annual inflation of 4% per year,
regardless of which economic state prevails in the future. Forecast sales and
production volumes, and total nominal variable costs, have already been forecast,
as follows:

Year 1 2 3 4

Sales and production (units) 150,000 250,000 400,000 300,000

Nominal variable cost ($000) 2,385 4,200 7,080 5,730 In

cremental overheads of $400,000 per year in current price terms will arise as a
result of undertaking the investment project. A large proportion of these
overheads relate to energy costs which are expected to increase sharply in the
future because of energy supply shortages, so overhead inflation of 10% per year
is expected. The initial investment will attract tax-allowable depreciation on a
straight-line basis over the four-year project life. The rate of corporation tax is
30% and tax liabilities are paid in the year in which they arise. Hraxin Co has

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traditionally used a nominal after-tax discount rate of 11% per year for
investment appraisal.

Required: (a) Calculate the expected net present value of the investment project
and comment on its financial acceptability.

(b) Critically discuss if sensitivity analysis will assist Hraxin Co in assessing the risk of
the investment project.

Case 2

Argnil Co is appraising the purchase of a new machine, costing $1·5 million, to


replace an existing machine which is becoming out of date and which has no
resale value. The forecast levels of production and sales for the goods produced
by the new machine, which has a maximum capacity of 400,000 units per year,
are as follows:

Year 1 2 3 4

Sales volume (units/year) 350,000 380,000 400,000 400,000

The new machine will incur fixed annual maintenance costs of $145,000 per year.
Variable costs are expected to be $3·00 per unit and selling price is expected to be
$5·65 per unit. These costs and selling price estimates are in current price terms
and do not take account of general inflation, which is forecast to be 4·7% per
year. It is expected that the new machine will need replacing in four years’ time
due to advances in technology. The resale value of the new machine is expected
to be $200,000 at that time, in future value terms. The purchase price of the new
machine is payable at the start of the first year of the four-year life of the
machine. Working capital investment of $150,000 will already exist at the start of
the four-year period, due to the operation of the existing machine. This
investment in working capital is expected to increase in nominal terms in line with
the general rate of inflation. Argnil Co pays corporation tax one year in arrears at
an annual rate of 27% and can claim 25% reducing balance tax-allowable
depreciation on the purchase price of the new machine. The company has a real

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after-tax weighted average cost of capital of 6% and a nominal after-tax weighted
average cost of capital of 11%.

Required: (a) Using a nominal terms net present value approach, evaluate
whether purchasing the new machine is financially acceptable.

(b) Discuss the reasons why investment finance may be limited, even when a
company has attractive investment opportunities available to it.

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