Capital Appraisal - Research Paper Example

Total Cost14,000,00022,400,00028,000,00019,600,0009,800,000Gross Profit (Rev-cost) 10,000,0008,400,00011,600,0006,800,000200,000Less: Depreciation Expense(1,600,000)(1,600,000)(1,600,000)(1,600,000)(1,600,000)Net Profit/Net Loss8,400,0006,800,00010,000,00052,000,000(1,400,000)Calculation of Cash FlowYears20082009201020112012Net Income/Net Loss8,400,0006,800,00010,000,00052,000,000(1,400,000)Add: Depreciation expense1,600,0001,600,0001,600,0001,600,0001,600,000Cash Flow10,000,0008,400,00011,600,0006,800,000200,000Present Value of Future Cash flowsYears20082009201020112012Interest factor0.6210.6830.7510.8260.

909Cash Flow10,000,0008,400,00011,600,0006,800,000200,000Present Value6,210,0005,737,2008,711,6005,616,800181,800Present Value of Terminal Cash Flow$Present Value Interest factor0.621Salvage Value + Working Capital4,000,000Present Value of Terminal Cash Flow2,484,000Calculation of Net Present Value$Present Value of Cash Flows26,457,400Present Value of Terminal Cash Flow2,484,000Total Cash Flow28,941,400Less: Initial Investment (17,050,000)Net Present Value11,891,400Option 2 Initial Investment (Cash Outflow)$Research & Development Expenditure5,000,000Since the manufacturing and marketing has been outsourced by Newton to another company Faraday Electricals Ltd, Newton does not have to bear any fixed or variable costs.

Calculation of IncomeYears20082009201020112012Royalty Payment (No. of Units)880,0001,540,0001,980,0001,320,000550,000x Royalty Payment/unit55555Total Income4,400,0007,700,0009,900,0006,600,0002,750,000The income is the cash flow that will be discounted at the present value factors as. 1. Newton has three options with respect to the operation of the business. The first option is to manufacture market and sell the products itself; the second option is to outsource the entire manufacturing and marketing of the products to another company Faraday Electricals Ltd and receive royalty payments and the third option is to sell the patent rights to Faraday Electricals Ltd and receive the money from it. 2. There are many factors that should be taken into account besides the calculation of Net Present Value (NPV) before making a decision.

If the payback period is calculated for option 1, it is 1.83 years which means that the initial investment is recovered in less than 2 years. Payback period for option 2 is 2.5 years and payback period for option 3 is 2.42 years. The payback period suggests that Newton should consider option 1 as it has the lowest payback period. However, payback period has its flaws which make it a less reliable method in making decisions. Firstly the payback method ignores all the cash flows that are generated after the payback period and secondly it gives equal weights to all the cash flows before the payback period despite the fact that the more distant cash flows are less valuable.

IRR for option 1 is 42%, IRR for option 2 is 25% and IRR for option 3 is 26%.