Purchasing the Lower-Cost Chip Crusher and Higher-Cost Chip Crusher - Case Study Example

Table of Contents Table of Contents 1 Executive summary 2 Introduction 2 1. Incremental cash flows 2 c) Annual operating costs (i.e. overheads, salaries and marketing) for each machine; 2 d) The $80,000 that was spent to rehabilitate the plan 2 Npv 3 Payback period 3 EAV Analysis 3 3. Risk analysis on the project 3 A. sensitivity analysis of NPVs to changes in annual processed scrap revenue and cost of capita 3 Effect of change in Scrap revenue on Npv;HCC Option 3 B. how far the annual net operating cash flow could fall short of forecast before the chip crusher would be rejected 4 C. Effect of inflation {2.5% per annum.} 4 4. Which chip crusher (LCC or HCC) they to invest 5 5. Reasons for your recommendation and any reservations 5 Reservation 5 Executive summary A venture must be appraised with the aid of after-tax incremental cash flows. Even though zero taxes is assumed in order to focus on the approach of assessment, it just significant cash flows of the period are the after all tax effect have been taken into consideration. Net present value is an important tool for summarizing the profitability traits of a venture. Introduction A capital budgeting decision is distinguished from expense as well as advantage that is realized over a long period of time which would lead to the need that the time value for money be taken into consideration so as to appraise the options precisely. Even though to make an investment decision should take into consideration the risk associated with it and also time value. It is an intricate exercise to assume the time value of money, furthermore, when the cash flows are permitted to be undecided, it may imply that THE employment of the process on the initial recommendation with certainty hypothesis will lost nothing b y making the certain assumption in the forecast. 1. Incremental cash flows The following are included as incremental cash flow analysis. b) Working capital investment which is 10% of annual scrap revenue; This will affect the incremental initial outlay and thus the effect in working capital changes will included in order realize an incremental initial cash outlay to be deducted from the cash flow on investment realized. c) Annual operating costs (i.e. overheads, salaries and marketing) for each machine; This is an operating cost that has direct impact on incremental cash flow which must be deducted from the incremental cash in order to realize the net incremental cash flows from investment. d) The $80,000 that was spent to rehabilitate the plan The cost of rehabilitating the plant is considered to be an incremental initial outlay which must be added to the cost of new plant in order to get net incremental initial outlay of the plant. 2. Which chip crusher (HCC or LCC) would you recommend? Npv The company should consider purchasing the lower-cost chip crusher (LCC)n since, it generate positive net present value which is quite more as compared to the net present value higher-cost chip crusher (HCC) IRR The LCC is depicting a higher IRR of 20.89% which is quite high as compared to IRR for HCC which is an Implication that an investment with high IRR would mean that the business will generate more returns within the shortest time possible. Payback period The LCC option will take 1.5 years to be repaid while for the HCC it will take 2.5 years to be repaid and thus the company should consider undertaking the LCC alternative since, the business will take the shortest time possible. EAV Analysis It can be observed that the EAV for LCC is higher as compared To the EAV for HCC which is an indication that LCC is an ideal investment alternative for the company since, the business will depict a high value of EAV within the shortest time possible. 3. Risk analysis on the project A. sensitivity analysis of NPVs to changes in annual processed scrap revenue and cost of capita Effect of change in Scrap revenue on Npv;HCC Option In order to undertake the sensitivity analysis for both project, we examine the worst and best scenario which is the +20 or -20% effect on both the scrap value and the cost of capital as well as asses its impact on the net present value in terms of pessimistic (-20%) and optimist(+20%) NPV as depicted in the table below. Variation in: Optimistic NPV Pessimistic NPV Range Scrap value±20% $163,585 -$120,270.00 $283,855 Cost of capital ±20% $292,449 -$129,865 $422,314 LCC Option Variation in: Optimistic NPV Pessimistic NPV Range Scrap value±20% $311,232 $48,938 $262,294 Cost of capital ±20% $292,449 $39,822 $252,627 It can therefore be observed that the impact of 20% change on HCC had an adverse effect since, under the worst scenario of -20%, the company would realize negative net present value while for the worst scenario in LCC, it can be depicted that the business would still realize positive net present value which is quite low and thus , it can be concluded that the company should consider undertaking the LCC option since, under best and worst scenario, the business will still realize positive net present value which is ideal to the company in terms of positive returns. B. how far the annual net operating cash flow could fall short of forecast before the chip crusher would be rejected Break analysis entails the assessment of the extent to which the company can operate before to earn no profit or loss. It is therefore the point at which the net present values equal zeros. From the analysis, it can be observed that LCC option will withstand 26% decline in revenue to $300,000 while for HCC will turn to be un foreseeable where the revenue declines to 260,000$ which implies 29% decline where the expense will grow by 33% to 330,500$. While LCC is combined utmost operating cost of $200,000. It can therefore be concluded that the LCC is not be susceptible to changes in variables which is an indication that the company should consider undertaking the LCC alternative due to small change on NPV. C. Effect of inflation {2.5% per annum.} The effect of inflation is that it will lead to an increase in operating cost with a decline in value of net realized form the venture and as a result, the breakeven point will reduce to a lesser units since, the time it takes for the NPV to equate to zero will be less due to less sales volume realized due to inflation growth by 2.5%. The value released in the breakeven point above wills therefore reduced by the same amount of inflation growth which is an indication that the inflation has direct impact on sales and cost and hence the breakeven point. 4. Which chip crusher (LCC or HCC) they to invest Taking into consideration all of the above factors that affect the business, the company therefore consider investing on LCC since, it will take the shortest time possible before the returns is realized to the investors as well as it depict a higher value of Net present value unlike the values for HCC. 5. Reasons for your recommendation and any reservations The sensitivity analysis performed on the two alternatives depict that the company should invest in LCC because, there is small variation cause by the change in cost of capital and scrap value to Net present value unlike the sensitivity analysis for HCC which depict a negative NPV under the pessimistic NPV. A project with shortest time would therefore depict less variation due to less uncertainties associated with forecasting the cash flow unlike the longest time forecasting which will be affected by future uncertainties And thus the project is susceptible to uncertainties as observed for HCC which has project life span of 6 years while LCC is 4 years implying less variation consequential from shortest forecast. Reservation Holding other factors constant, the project forecast is assumed to be precise and thus the external factors such as fierce completion and available market for the business will not affect business operation and thus the business operate into unforeseeable future. The forecast and sensitivity analysis on the project is therefore made on assumption basis and not based on real life situation in this regards. The outcome will not be exact but we are 95% confident that the outcome will be achievable and significant for our analysis and investment decision making that is deem viable for the business growth as for the case of NOVA tractors limited. Appendices Depreciation Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Asset (500,000*0.4) 300000*0.4 180000*40% 72000*40% 28800 17280 Depreciation -200,000 120,000 -72000 -43200 -11520 -6912 Net book value 300,000 180,000 108,000 28800 17280 10368 After tax sales Sales 500,000 350000 245000 171500 120050 84035 Net of tax (0.7) 0.7 0.7 0.7 0.7 0.7 0.7 Net of tax 350000 245000 171500 120050 84035 58824.5 After tax operating costs Annual Operating cost 308000 123200 49280 19712 8884.8 3553.92 Tax 40% 0.4 0.4 0.4 0.4 0.4 0.4 123200 49280 19712 7884.8 3553.92 1421.568 Capital Gain Net book value 10368 Residual value -45000 Capital Gain -34632 Tax rate 0.3 -10389.6 Working capital changes 10% of scrap (45000*10) 4500 NOVA TRACTOR CORPORATION Incremental Cash Flow Table     Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Purchase cost   -$500,000           Working capital changes   $4,500           Tax saving from govt. investment allowance (200000 x 11%) x 30% $6,600           Redundancy payout avoided   $100,000           Tax savings from depreciation expense (500000 * 40%) x 30% -200,000 120,000 -72000 -43200 -11520 -6912 After tax sales Sales before tax x (1 - 30%)   350000 245000 171500 120050 84035 58824.5 After tax operating costs 40% x after tax sales   -123200 -49280 -19712 -7884.8 3553.92 1421.57 Sale of fabrication machine               $45,000 Tax paid on capital gain from sale of machine 30% tax rate x capital gain (0.3*34632)           -$10,390                 Annual after-tax net cash flows   -$388,900 $26,800 $315,720 $79,788 $68,965 $76,069 $87,944 Company RoR, or WACC 12% Net Present Value (NPV) $261,600.38 Profitability Index 1.673 Internal Rate of Return (IRR) 15.328% Lower-cost chip crusher (LCC) Depreciation Year 0 Year 1 Year 2 Year 3 Year 4 Asset (400,000*0.35) 260000*0.35 169000*35% 109850*35% Depreciation -140,000 -91,000 -59150 -38447.5 Tax saving 30% 0.3 0.3 0.3 0.3   -42000 -27300 -17745 -11534.3 After tax sales Sales 520,000 364000 254800 178360 Net of tax (0.7) 0.7 0.7 0.7 0.7 Net of tax 364000 254800 178360 124852 After tax operating costs Annual Operating cost 308000 123200 49280 19712 Tax 40% 0.4 0.4 0.4 0.4 123200 49280 19712 7884.8 Capital Gain Net book value 98316 Residual value -45000 Capital Gain 53316 Tax rate 0.3 15994.8 Working capital changes 10% of scrap (25000*10) 2500 Incremental cash flow (LCC) NOVA TRACTOR CORPORATION Incremental Cash Flow Table     Year 0 Year 1 Year 2 Year 3 Year 4 Purchase cost   -$400,000         Working Capital Changes   $2,500         Tax saving from govt. investment allowance (200000 x 11%) x 30% $6,600         Redundancy payout avoided   $100,000         Tax savings from depreciation expense (500000 * 40%) x 30% -42000 -27300 -17745 -11534.3 After tax sales Sales before tax x (1 - 30%)   364000 254800 178360 124852 After tax operating costs 40% x after tax sales   -123200 -49280 -19712 -7884.8 Sale of fabrication machine           $25,000 Tax paid on capital gain from sale of machine 30% tax rate x capital gain (0.3*34632)       -$15,995               Annual after-tax net cash flows   -$290,900 $198,800 $178,220 $140,903 $114,438 Company RoR, or WACC 12% Net Present Value (NPV) $558,014.00 Profitability Index 2.900 Internal Rate of Return (IRR) 20.897% NOVA TRACTOR CORPORATION: Calculating the EAV for two projects of unequal lives HCC project with 6 years of cash flows From the earlier incremental cash flow table… Year: 0 1 2 3 4 5 6 Annual after-tax cash flows ($388,900) $26,800 $315,720 $79,788 $68,965 $76,069 $87,944 Company RoR 12% Net Present Value (NPV) $261,600.38 EAV HCC $72,570.49 Cell formula: =pmt(rate, number of payments, -NPV,0,0) NOVA TRACTOR CORPORATION: Calculating the EAV for two projects of unequal lives HCC project with 4 years of cash flows Year: 0 1 2 3 4     Annual after-tax cash flows ($290,900) $198,800 $178,220 $140,903 $114,438 Company RoR 12% Net Present Value (NPV) 558,014.00 EAV LCC $183,717.42 Cell formula: =pmt(rate, number of payments, -NPV,0,0) Sensitivity Analysis HCC Alternative NOVA TRACTOR CORPORATION Incremental Cash Flow Table;optimistic change (20% increment in scrap value)     Year 0 Year 1 Year 2 Year 3 Year 4 Year 5   Depreciation Purchase cost   -$580,000           Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Working capital changes   $4,500           Asset (500,000*0.4) 300000*0.4 180000*40% 72000*40% 28800 17280 Tax saving from govt. investment allowance (200000 x 11%) x 30% $6,600           Depreciation -200,000 120,000 -72000 -43200 -11520 -6912 Redundancy payout avoided   $100,000           Net book value 300,000 180,000 108,000 28800 17280 10368 Tax savings from depreciation expense (500000 * 40%) x 30% -200,000 120,000 -72000 -43200 -11520 -6912 After tax sales Sales before tax x (1 - 30%)   420000 294000 205800 144060 100842 70589.4 After tax sales After tax operating costs 40% x after tax sales   -123200 -49280 -19712 -7884.8 3553.92 1421.57 Sales 500,000 350000 245000 171500 120050 84035 Disposal               $45,000 Net of tax (0.7) 0.7 0.7 0.7 0.7 0.7 0.7 Tax paid on capital gain from sale of machine 30% tax rate x capital gain (0.3*34632)           -$10,390 Net of rax 350000 245000 171500 120050 84035 58824.5                 20% increment 1.2 1.2 1.2 1.2 1.2 1.2 Annual after-tax net cash flows   -$468,900 $96,800 $364,720 $114,088 $92,975 $92,876 $99,709 Net sales 420000 294000 205800 144060 100842 70589.4       Company RoR, or WACC 13% After tax operating costs 308000 123200 49280 19712 8884.8 3553.92 Net Present Value (NPV) $83,584.61 Annual Operating cost 0.4 0.4 0.4 0.4 0.4 0.4 Profitability Index 1.178 Tax 40% 123200 49280 19712 7884.8 3553.92 1421.568 Internal Rate of Return (IRR) 24.478% Capital Gain 10368     Net book value -45000 Residual value -34632 Capital Gain 0.3 Tax rate -10389.6 Working capital changes (45000*10) 4500 10% of scrap                                       HCC Alternative NOVA TRACTOR CORPORATION Incremental Cash Flow Table;pessimistic change (-20% increment in scrap value)     Year 0 Year 1 Year 2 Year 3 Year 4 Year 5   Depreciation Purchase cost   -$580,000           Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Working capital changes   $4,500           Asset (500,000*0.4) 300000*0.4 180000*40% 72000*40% 28800 17280 Tax saving from govt. investment allowance (200000 x 11%) x 30% $6,600           Depreciation -200,000 120,000 -72000 -43200 -11520 -6912 Redundancy payout avoided   $100,000           Net book value 300,000 180,000 108,000 28800 17280 10368 Tax savings from depreciation expense (500000 * 40%) x 30% -200,000 120,000 -72000 -43200 -11520 -6912 After tax sales Sales before tax x (1 - 30%)   280000 196000 137200 96040 67228 47059.6 After tax sales After tax operating costs 40% x after tax sales   -123200 -49280 -19712 -7884.8 3553.92 1421.57 Sales 500,000 350000 245000 171500 120050 84035 Disposal               $45,000 Net of tax (0.7) 0.7 0.7 0.7 0.7 0.7 0.7 Tax paid on capital gain from sale of machine 30% tax rate x capital gain (0.3*34632)           -$10,390 Net of rax 350000 245000 171500 120050 84035 58824.5                 20% increment 0.8 0.8 0.8 0.8 0.8 0.8 Annual after-tax net cash flows   -$468,900 -$43,200 $266,720 $45,488 $44,955 $59,262 $76,180 Net sales 280000 196000 137200 96040 67228 47059.6       Company RoR, or WACC 13% After tax operating costs 308000 123200 49280 19712 8884.8 3553.92 Net Present Value (NPV) -$209,865.50 Annual Operating cost 0.4 0.4 0.4 0.4 0.4 0.4 Profitability Index 0.552 Tax 40% 123200 49280 19712 7884.8 3553.92 1421.568 Internal Rate of Return (IRR) -1.211% Capital Gain 10368     Net book value -45000 Residual value -34632 Capital Gain 0.3 Tax rate -10389.6 Working capital changes (45000*10) 4500 10% of scrap Read More