1000-words Write a memo to the general manager explaining your analysis for the specialty spark plug project.
Include the following information:
Present the NPV and IRR calculated for the purchase of new equipment.
Calculate the payback period for the new equipment project.
Make a recommendation about the manufacture of the specialty spark plug and purchase of new equipment.
Present the NPV and IRR calculated for the purchase of new equipment and payback.
—Discuss the effect of a volume increase in sales, a price increase in sales, and a cost decrease on the net operating income.
—Make a recommendation about the manufacture of the specialty spark plug and purchase of new equipment. Use APA F
SAC is considering a proposal to increase the revenue of the business by increasing the activity. It has a proposal to purchase another equipment so as to increase the production of specialty Spark plugs. The production is expected to increase by 100,000 plugs. The cost of the equipment is $3,000,000 with a life of 5 years. The cost of manufacturing each plug is $8 and the plugs can be sold at $20. Thus there is incremental revenue of $12 per plug.
Objective: To analyze and decide whether or not to purchase the equipment.
Criteria: To decide with the help of capital budgeting techniques like payback period, NPV and IRR.
To apply these techniques of capital budgeting for decision making the estimated cash flows should be first ascertained.
Cash flows for each year are ascertained as follows:
Incremental revenue (100,000 x 12)1,200,000
Less depreciation *-600,000
Profit before taxes600,000
Less taxes (34%)204,000
Profit after taxes396,000
Add depreciation **600,000
Cash flow after taxes996,000
*Depreciation = 3,000,000/5 = 600,000
**Depreciation is a non cash expense and thus is added back to profits after taxes.
1)Payback period:
The length of time required to recover the cost of an investment.
Calculated as:
Payback period = cost of project/Annual cash inflows
Decisions are based on the time required to recover the cost of investment. The earlier the better is the rule which is followed in this case.
Limitation: It suffers from a serious limitation which is the cash flows are not discounted as per the present value.
Calculation of payback period in the case of SAC is as follows:
Year / Cash flows after taxes0 / -3,000,000
1 / 996,000
2 / 996,000
3 / 996,000
4 / 996,000
5 / 996,000
Payback period = 3,000,000/996,000 = 3.01 years.
2)NPV method:
Net present value (NPV) or net present worth (NPW)[1] is defined as the total present value (PV) of a time series of cash flows. It is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met.
Calculation of NPV in case of SAC:
The cashflows are discounted at the overall cost of capital of the company which is calculated as follows:
WACC = weight of debt x cost of debt + weight of equity x cost of equity
= 0.4 x 6% (1 - 0.34) + 0.6 x 14%
= 1.584% + 8.4%
= 9.984%
Year / Incremental profit / Depreciation / Net profit / Taxes (34%) / Profit after taxes / Cash flows after taxes0 / -3,000,000
1 / 1,200,000 / 600,000 / 600,000 / 204000 / 396,000 / 996,000
2 / 1,200,000 / 600,000 / 600,000 / 204000 / 396,000 / 996,000
3 / 1,200,000 / 600,000 / 600,000 / 204000 / 396,000 / 996,000
4 / 1,200,000 / 600,000 / 600,000 / 204000 / 396,000 / 996,000
5 / 1,200,000 / 600,000 / 600,000 / 204000 / 396,000 / 996,000
Total present value @9.984% = / $3,777,167.40
NPV = / $777,167.40
IRR = / 20%
Internal Rate of Return - IRR
Thediscount rate often used in capital budgeting that makes the net present value of all cash flows from a particular projectequal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.
Decision:
In case of SAC, Net present value is positive which means that the present value of cash inflows is greater the present investment to be made now. The IRR is greater than the overall cost of capital. Thus it is concluded that the project is acceptable and the new machinery can be purchased to increase the revenue.
Explain the effect of a sales volume increase on the total fixed costs, unit fixed costs, total variable cost, and unit variable cost.
The effect of sales volume increase on Total fixed cost, unit fixed cost, Total variable cost and unit variable cost:
Fixed costs remain constant in the short run even when sales volume varies. Examples include salaries and rent. If there is a change in capacity to provide goods and services then there will be a change in fixed cost which is also known as capacity fixed costs. Though fixed costs are constant in the short run they vary in the long run and all fixed costs in the long run may be viewed as variable costs.
As the sales volume increases fixed cost per unit decreases.
Variable costs vary proportionately with the change in sales volume.
Variable cost per unit remains constant as the total variable costs varies proportionately with sales volume.
Discuss the effect of a volume increase in sales, a price increase in sales, and a cost decrease on the net operating income.
The effect of a volume increase in sales, a price increase in sales, and a cost decrease on the net operating income:
Increase in sales volume will increase net income.
The increase in selling price also increases the net operating income.
Cost reduction results in profit maximization and thus it is concluded that the net income will increase if there is a cost decrease.
Recommendation:
SAC should purchase the new equipment and increase the manufacture of Spark plugs as the overall profit can be increased.
Based on the Capital budgeting techniques the following conclusions can be drawn.
- The payback period is 3 years whereas the project life time is 5 years. The net present value is positive and the IRR is greater than the overall cost of capital.
Based on the behavior of cost the following conclusions can be drawn.
- An increase in sales volume, and decrease in costs will result in increase in net income for the company.
Thus SAC should purchase the new equipment and increase the manufacture of spark plugs which results in increase in net income.
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