Milan Ltd. wants to purchase a new machine for its factory operations at a cost of £380,000. This cost would be paid off in four installments: an immediate payment of £170,000, and a payment of £70,000 at the end of each of the next three years. The investment is expected to generate £80,000 in annual cash flows for a period of six years. The annual operating costs associated with the new machine are estimated to be £118,000 per year, including depreciation. These cash flows and costs will generally occur throughout the year and are recognized at the end of each year. Additional information: 1. The old machine can be sold for £25,000. 2. The new machine is expected to have the terminal disposal value £32,000 at the end of a six-year period. 3. Depreciation of the new machine is calculated using the straight-line method. 4. Major maintenance cost at the end of Year 3 will be £55,000 and at the end of Year 5 will be £30,000. 5. An additional cash investment in working capital of £20,000 will be required. It will be recovered at the end of the project. 6. Milan Ltd. will employ two highly skilled machine operators who each will earn £33,000 per year. 7. The new machine will allow Milan Ltd. to replace 7 skilled employees who each earns on average £28,000 per year. If the employees get fired, each of them is entitled to statutory redundancy pay 15% of their annual salary. There is a 70% probability that redundancy will result in strike action. If it is successful (a 60% probability), in addition to statutory redundancy pay employees will receive extra compensation equal to 20% of their annual salary. 50% of this compensation Milan Ltd. will be obliged to pay employees immediately upon redundancy, 30% - one year after redundancy whereas the remaining 20% - two years after redundancy. 8. To ensure that the new machine works at maximum efficiency, Milan Ltd. will need to lease a special energy generator at an annual lease cost of £45,000. The lease period would run for six years, with each payment being due at the beginning of the year. Calculate the net present value (NPV) of this project assuming Milan Ltd.’s required rate of return is 8%.
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.
Milan Ltd. wants to purchase a new machine for its factory operations at a cost of £380,000. This cost would be paid off in four installments: an immediate payment of £170,000, and a payment of £70,000 at the end of each of the next three years. The investment is expected to generate £80,000 in annual cash flows for a period of six years. The annual operating costs associated with the new machine are estimated to be £118,000 per year, including depreciation. These cash flows and costs will generally occur throughout the year and are recognized at the end of each year.
Additional information:
1. The old machine can be sold for £25,000.
2. The new machine is expected to have the terminal disposal value £32,000 at
the end of a six-year period.
3. Depreciation of the new machine is calculated using the straight-line method.
4. Major maintenance cost at the end of Year 3 will be £55,000 and at the end of
Year 5 will be £30,000.
5. An additional cash investment in working capital of £20,000 will be required. It
will be recovered at the end of the project.
6. Milan Ltd. will employ two highly skilled machine operators who each will earn
£33,000 per year.
7. The new machine will allow Milan Ltd. to replace 7 skilled employees who each
earns on average £28,000 per year. If the employees get fired, each of them is entitled to statutory redundancy pay 15% of their annual salary. There is a 70% probability that redundancy will result in strike action. If it is successful (a 60% probability), in addition to statutory redundancy pay employees will receive extra compensation equal to 20% of their annual salary. 50% of this compensation Milan Ltd. will be obliged to pay employees immediately upon redundancy, 30% - one year after redundancy whereas the remaining 20% - two years after redundancy.
8. To ensure that the new machine works at maximum efficiency, Milan Ltd. will need to lease a special energy generator at an annual lease cost of £45,000. The lease period would run for six years, with each payment being due at the beginning of the year.
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