ABC Manufacturing expects to sell 1,025 units of product in 2023 at an average price of $100,000 per unit based on current demand. The Chief Marketing Officer forecasts growth of 50 units per year through 2027. So, the demand will be 1,025 units in 2023, 1,075 units in 2024, etc. and the $100,000 price will remain consistent for all five years of the investment life. However, ABC cannot produce more than 1,000 units annually based on current capacity. In order to meet demand, ABC must either update the current plant or replace it. The old equipment is fully depreciated and can be sold for $4,000,000 if the plant is replaced. If the plant is updated, the costs to update it would be capitalized and depreciated over the useful life of the updated plant. If the plant is updated, then the old equipment would be retained. The following table summarizes the projected data for both options: Update Replace Initial investment in 2023 $100,000,000 $150,000,000 Terminal disposal value in 2027 $5,000,000 $20,000,000 Useful life 5 years 5 years Total annual cash operating costs per unit $76,000 $65,000 ABC uses straight-line depreciation, assuming zero terminal disposal value. Assume no changes in prices or costs during future years. The investment will be made at the beginning of 2023 and all cash flows after that are assumed to occur on the last day of each year. ABC's required rate of return is 8%. Assume an income tax rate of 20%. Proceeds from sales of equipment above book value are taxed at the same 20% rate. Required: 1. Using Excel functions, calculate the net present value (NPV) and the project profitability index (PPI) for the update and replace alternatives. 2. Using Excel functions, calculate the internal rate of return (IRR) for both the update and replace alternatives. 3. Calculate the payback period for the update and replace alternatives. 4. Based on the results, which option should ABC choose? Specifically explain why.
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
ABC Manufacturing expects to sell 1,025 units of product in 2023 at an average price of $100,000 per unit based on current demand.
The Chief Marketing Officer
in 2024, etc. and the $100,000 price will remain consistent for all five years of the investment life. However, ABC cannot produce more than 1,000 units annually based on current capacity.
In order to meet demand, ABC must either update the current plant or replace it. The old equipment is fully depreciated and can be sold for $4,000,000 if the plant is replaced. If the plant is updated, the costs to update it would be capitalized and depreciated over the useful life of the updated plant. If the plant is updated, then the old equipment would be retained. The following table summarizes the projected data for both options:
Update Replace
Initial investment in 2023 $100,000,000 $150,000,000
Terminal disposal value in 2027 $5,000,000 $20,000,000
Useful life 5 years 5 years
Total annual cash operating costs per unit $76,000 $65,000
ABC uses straight-line depreciation, assuming zero terminal disposal value. Assume no changes in
prices or costs during future years. The investment will be made at the beginning of 2023 and all cash flows after that are assumed to occur on the last day of each year. ABC's required
Assume an income tax rate of 20%. Proceeds from sales of equipment above book value are taxed at the same 20% rate. Required:
1. Using Excel functions, calculate the
2. Using Excel functions, calculate the
4. Based on the results, which option should ABC choose? Specifically explain why.
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