The directors of Pelta Co are considering a planned investment project costing $25m, payable at the start of the first year of operation. The following information relates to the investment project: Year 1 Year 2 Year 3 Year 4 Sales volume (units/year) 520,000 624,000 717,000 788,000 Selling price ($/unit) 30·00 30·00 30·00 30·00 Variable costs ($/unit) 10·00 10·20 10·61 10·93 Fixed costs ($/year) 700,000 735,000 779,000 841,000 This information needs adjusting to take account of selling price inflation of 4% per year and variable cost inflation of 3% per year. The fixed costs, which are incremental and related to the investment project, are in nominal terms. The year 4 sales volume is expected to continue for the foreseeable future. Pelta Co pays corporation tax of 30% one year in arrears. The company can claim tax-allowable depreciation on a 25% reducing balance basis. The views of the directors of Pelta Co are that all investment projects must be evaluated over four years of operations, with an assumed terminal value at the end of the fourth year of 5% of the initial investment cost. Both net present value and discounted payback must be used, with a maximum discounted payback period of two years. The real after-tax cost of capital of Pelta Co is 7% and its nominal after-tax cost of capital is 12%. Required: (a) (i) Calculate the net present value of the planned investment project. (ii) Calculate the discounted payback period of the planned investment project. (b) Discuss the financial acceptability of the investment project. (c) Critically discuss the views of the directors on Pelta Co’s investment appraisal.
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.
The directors of Pelta Co are considering a planned investment project costing $25m, payable
at the start of the first year of operation. The following information relates to the investment
project:
Year 1 Year 2 Year 3 Year 4
Sales volume (units/year) 520,000 624,000 717,000 788,000
Selling price ($/unit) 30·00 30·00 30·00 30·00
Variable costs ($/unit) 10·00 10·20 10·61 10·93
Fixed costs ($/year) 700,000 735,000 779,000 841,000
This information needs adjusting to take account of selling price inflation of 4% per year and
variable cost inflation of 3% per year. The fixed costs, which are incremental and related to the
investment project, are in nominal terms. The year 4 sales volume is expected to continue for
the foreseeable future.
Pelta Co pays corporation tax of 30% one year in arrears. The company can claim tax-allowable
depreciation on a 25% reducing balance basis.
The views of the directors of Pelta Co are that all investment projects must be evaluated over
four years of operations, with an assumed terminal value at the end of the fourth year of 5% of
the initial investment cost. Both
a maximum discounted payback period of two years. The real after-tax cost of capital of Pelta
Co is 7% and its nominal after-tax cost of capital is 12%.
Required:
(a) (i) Calculate the net present value of the planned investment project.
(ii) Calculate the discounted payback period of the planned investment project.
(b) Discuss the financial acceptability of the investment project.
(c) Critically discuss the views of the directors on Pelta Co’s investment appraisal.
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