Project a involves adding a new component to an automobile’s emissions control system. Initially available only for Ford vehicles, it will be available for other models later. Because of its potential axis, it may have to compete with new entrants who want to manufacture and sell similar products.
Project B is a special air conditioner adapter for older Ford and his GM vehicles. New vehicles from Ford and GM will have this item as standard equipment, but there will likely be an immediate market in China. Many Chinese customers want American cars, but cannot afford the full price of new models.
Axis Corporation plans to expand its business by investing in new projects to manufacture new advanced automotive spare parts. The company has two potential projects for him. One is to manufacture new components for automobile emissions control systems and the other is to manufacture air conditioning adapters for Ford and his GM vehicles. The report evaluates and analyzes both investment projects using capital budgeting and investment valuation techniques to help select the most viable investment option.
Our product staff estimates the expected demand for our products, resulting in expected sales for the next three years. In addition, it was estimated that the cost of goods sold accounted for his 60% of sales revenue. Therefore, before choosing an investment proposal among the available projects, it is necessary to evaluate and analyze the profitability and feasibility of the project. Using a straight-line depreciation estimate, a 30% tax rate, and a 14% discount rate, the project can be valued using the following investment valuation techniques.
Project A requires the following initial investment. It is priced at $120,000 and has an expected life of 3 years. Based on the estimated sales amount estimated by the production staff, the following analysis is possible.
|Initial investment||$ 120,000|
|Life of the project (In years)||3|
|Cost of goods sold||60%|
|Sales revenue||$ 120,000||$ 170,000||$ 370,000|
|Cost of goods sold||$ (72,000)||$ (102,000)||$ (222,000)|
|Gross profit||$ 48,000||$ 68,000||$ 148,000|
|Depreciation expense||$ (40,000)||$ (40,000)||$ (40,000)|
|Profit before tax||$ 8,000||$ 28,000||$ 108,000|
|Provision for tax||$ (2,400)||$ (8,400)||$ (32,400)|
|Profit after tax||$ 5,600||$ 19,600||$ 75,600|
|Add: Depreciation||$ 40,000||$ 40,000||$ 40,000|
|Cash flow generated from operations||$ 45,600||$ 59,600||$ 115,600|
|Initial investment||$ (120,000)|
|Free cash flows||$ (120,000)||$ 45,600||$ 59,600||$ 115,600|
|Discounted cash flows||$ (120,000)||$ 40,000||$ 45,860||$ 78,027|
|Cumulative cash flows||$ (120,000)||$ (80,000)||$ (34,140)||$ 43,887|
|Fraction in years||0.4375|
|Net present value (NPV)||$ 43,887|
|Internal rate of return (IRR)||31%|
|Discounted payback period||2.44|
|Profitability index (PI)||1.37|
|Accounting rate of return (ARR)||61.33%|
From the above analysis, we can see that Project A generates $45,600 of net cash flow from operations in its first year, with a significant increase in cash flow thereafter. We can see that Project A has an NPV of $43,887 and an internal rate of return of 31%. The discounted payback period is 2.44 years, the profitability index is 1.37, and the accounting rate of return is 61.33%.
Project B requires an initial investment of $130,000. This is based on the lifetime of the project. depreciated to zero. By estimating expected revenue, tax rates, and discount rates, you can perform the following analyses:
|Initial investment||$ 130,000|
|Life of the project (In years)||3|
|Cost of goods sold||60%|
|Sales revenue||$ 375,000||$ 130,000||$ 110,000|
|Cost of goods sold||$ (225,000)||$ (78,000)||$ (66,000)|
|Gross profit||$ 150,000||$ 52,000||$ 44,000|
|Depreciation expense||$ (43,333)||$ (43,333)||$ (43,333)|
|Profit before tax||$ 106,667||$ 8,667||$ 667|
|Provision for tax||$ (32,000)||$ (2,600)||$ (200)|
|Profit after tax||$ 74,667||$ 6,067||$ 467|
|Add: Depreciation||$ 43,333||$ 43,333||$ 43,333|
|Cash flow generated from operations||$ 118,000||$ 49,400||$ 43,800|
|Initial investment||$ (130,000)|
|Free cash flows||$ (130,000)||$ 118,000||$ 49,400||$ 43,800|
|Discounted cash flows||$ (130,000)||$ 103,509||$ 38,012||$ 29,564|
|Cumulative cash flows||$ (130,000)||$ (26,491)||$ 11,520||$ 41,084|
|Fraction in years||0.6969||0.3897|
|Net present value (NPV)||$ 41,084|
|Internal rate of return (IRR)||37%|
|Discounted payback period||1.70|
|Profitability index (PI)||1.32|
|Accounting rate of return (ARR)||54.15%|
From the above analysis, it can be seen that the cash flow generated by the operation of the project was 118,000 Baht in the first year, but the cash flow generation gradually decreased in the following years. The project has a net present value of $41,084 and an internal rate of return of 37%. The discount payback period for this project will be short at 1.7 years. Project B has an accounting rate of return of 54.15% and a profitability index of 1.32.
|Market price of preferred stock||$ 115.50|
|Face value||$ 100.00|
|Annual dividend||$ 10.00|
|Cost of preference share||8.66%|
|Face value of the bond||$ 1,000.00|
|Current price of the bond||$ 922.87|
|Capital yield||$ 77.13|
|Yield to maturity||8%|
|Present value of capital yield||$ 61.23|
|Net proceeds||$ 861.64|
|Annual interest||$ 50.00|
|Cost of bond||5.80%|
|Risk free rate||1.50%|
|Cost of equity using CAPM||13.74%|
|Current dividend||$ 2.07|
|Market price of the shares||$ 50.00|
|Dividend growth rate||5%|
|Cost of equity using dividend growth model||9.14%|
|Computation of weighted average cost of capital:|
|Source of capital||Amount||Cost||Weighted cost|
|Equity and retained earnings||200000||13.74%||5.5%|
|Weighted average cost of capital||9.0%|
From the above calculation, the company’s weighted average cost of capital is 9%. If we take the weighted average cost of capital as the required rate of return, we can conclude that both projects have a higher IRR than the required rate of return and Project B has a higher IRR.
Conclusions and Recommendations
From the discussion and analysis above, Project A performs better than Project A because both projects have positive NPV. We can conclude that it is possible. Project B has a higher internal rate of return and a shorter payback period, but Project A provides higher capital accumulation than Project B. Therefore, we recommend that you choose Project A for your investment.
ReferencesAlkaraan, Fadi. “Strategic investment decision-making perspectives.” Advances in mergers and acquisitions 14 (2015): 53-66.
Baum, Andrew E., and Neil Crosby. Property investment appraisal. John Wiley & Sons, 2014.
Harris, Elaine. Strategic project risk appraisal and management. Routledge, 2017.
Nadkarni, G. A. “Investment appraisal in industrial undertakings.” (2016).
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