RWE Enterprises Ltd is a small manufacturing firm located in New Plymouth. The firm is engaged in the manufacture and sale of feed supplements used by cattle raisers. The product has molasses base but is supplemented with minerals and vitamins that are generally thought to be essential to the health and growth of beef cattle. The final product is put in 75-kg or 100-kg tubs that are then made available for the cattle to lick as desired. The material in the tub becomes very hard, which limits the animal’s consumption.
The firm has been running a single production line for the past five years and is considering the addition of a new line. The addition would expand the firm’s capacity by almost 120% because the newer equipment requires a shorter downtime between batches. After each production run, the boiler used to prepare the molasses for the additional minerals and vitamins must be heated to 85 degrees Celsius and then must be cooled before beginning the next batch. The total production run entails about four hours and the cool-down period is two hours (during which time the whole process comes to a halt). Using two production lines increases the overall efficiency of the operation because workers from the line that is cooling can be moved to the other line to support the ‘canning’ process involved in filling the feed tubs.
The equipment for the second production line will cost $3 million to purchase and install and will have an estimated after-tax scrap value of $200,000. Furthermore, at the end of five years, the production line will have to be refurbished at an estimated cost of $2 million. RWE’s management estimates that the new production line will add $700,000 per year in after tax cash flows to the firm.
Required:
a) If RWE uses a 10% discount factor to evaluate investments of this type, what is the net present value of the project? What does this NPV indicate about the potential value RWE might create by purchasing the new production line? (6 marks)
b) Calculate the internal rate of return and profitability index for the proposed investment. What do these two measures tell you about the project’s viability? (6 marks)
c) Calculate the payback and discounted payback periods for the proposed investment. Interpret your findings. (4 marks)
d) What is the rationale of using MIRR as opposed to IRR decision criteria? Describe the fundamental shortcoming of the MIRR method (5 marks)
t for the second production line will cost $3 million to purchase
esimated after-tax scrap value of $200,000.
at the end of five years, the production line will have to be refurbished at an estimated cost of $2 million.
RWE’s management estimates that the new production line will add $700,000 per year in after tax cash flows to the firm.
10% discount factor
| Year | Initial investment |
Cash Inflow | Salvage value |
Total cash flow |
Pv factor @10% | Prasen Value |
| 0 | -3000000 | -3000000 | 1 | -3000000 | ||
| 1 | 700000 | 700000 | 0.909091 | 636363.6 | ||
| 2 | 700000 | 700000 | 0.826446 | 578512.4 | ||
| 3 | 700000 | 700000 | 0.751315 | 525920.4 | ||
| 4 | 700000 | 700000 | 0.683013 | 478109.4 | ||
| 5 | -1300000 | -1300000 | 0.620921 | -807198 | ||
| 6 | 700000 | 700000 | 0.564474 | 395131.8 | ||
| 7 | 700000 | 700000 | 0.513158 | 359210.7 | ||
| 8 | 700000 | 700000 | 0.466507 | 326555.2 | ||
| 9 | 700000 | 700000 | 0.424098 | 296868.3 | ||
| 10 | 700000 | 200000 | 900000 | 0.385543 | 346989 | |
| 136463 |
Project should be accepted as NPV is positive
(2)
Calculate the internal rate of return and profitability index for the proposed investment. What do these two measures tell you about the project’s viability
Irr will be calculates as follow by trial and error method
IRR = -3000000 +700000(1+r)1+700000(1+r)2+700000(1+r)3+700000(1+r)4+-13000000(1+r)5+700000(1+r)6+700000(1+r)7+700000(1+r)8+700000(1+r)9+900000(1+r)10
By using trial and error method we have found IRR as follow
= 11.05%
conclusion
AS IRR of the project is 11.05% which means project gives more return then the required raste i.e. 10% so project should be accepted
c) Calculate the payback and discounted payback periods for the proposed investment. Interpret your findings. (4 marks)
| Year | Initial investment |
Cash Inflow | Salvage value |
Total cash flow |
Incremantal Cash Flow |
| 0 | -3000000 | -3000000 | |||
| 1 | 700000 | 700000 | 700000 | ||
| 2 | 700000 | 700000 | 1400000 | ||
| 3 | 700000 | 700000 | 2100000 | ||
| 4 | 700000 | 700000 | 2800000 | ||
| 5 | -1300000 | -1300000 | 1500000 | ||
| 6 | 700000 | 700000 | 2200000 | ||
| 7 | 700000 | 700000 | 2900000 | ||
| 8 | 700000 | 700000 | 3600000 | ||
| 9 | 700000 | 700000 | 4300000 | ||
| 10 | 700000 | 200000 | 900000 | 5200000 |
| Required | -3000000 |
| At the end of 7 year |
2900000 |
| Remaining | -100000 |
| In eight year | 700000 |
| So days =365*100000/7000000 |
52.14285714 |
| Payback period | 7 year and 52 days |
Discounted Payback will be calculated as follow
| Year | Initial investment |
Cash Inflow | Salvage value |
Total cash flow |
Pv factor @10% | Prasen Value | Incremental Cash Flo |
| 0 | -3000000 | -3000000 | 1 | -3000000 | |||
| 1 | 700000 | 700000 | 0.909091 | 636363.6 | 636363.6364 | ||
| 2 | 700000 | 700000 | 0.826446 | 578512.4 | 1214876.033 | ||
| 3 | 700000 | 700000 | 0.751315 | 525920.4 | 1740796.394 | ||
| 4 | 700000 | 700000 | 0.683013 | 478109.4 | 2218905.812 | ||
| 5 | -1300000 | -1300000 | 0.620921 | -807198 | 1411708.092 | ||
| 6 | 700000 | 700000 | 0.564474 | 395131.8 | 1806839.844 | ||
| 7 | 700000 | 700000 | 0.513158 | 359210.7 | 2166050.526 | ||
| 8 | 700000 | 700000 | 0.466507 | 326555.2 | 2492605.692 | ||
| 9 | 700000 | 700000 | 0.424098 | 296868.3 | 2789474.025 | ||
| 10 | 700000 | 200000 | 900000 | 0.385543 | 346989 | 3136462.986 |
| Required | -3000000 |
| At the end of 9year |
2789474.025 |
| Remaining | -210525.975 |
| In eight year | 346989 |
| So days =365*210525.975/3136462.968 |
24.4995658 |
| Payback period | 9year and 24 days |
Discounted Payback is 9 year and 24 days
d) What is the rationale of using MIRR as opposed to IRR decision criteria? Describe the fundamental shortcoming of the MIRR method (5 marks)
MIRR assume that any positive cash inflow of the project is reinvested at the firms cost of capital and initial outlays are financed at the at the firms financing cost
The formula for MIRR is:
As against to these IRR assumes that any positive cash inflow of the project is reinvested at the firm at IRR.So MIRR more accurately reflects the cost and profitability of the project initiated.
