Armstrong Ltd manufactures watertight metal cases for electronic equipment used on ships. Armstrong

has divisions operating throughout Australia. Division managers receive a bonus each year based on their

accrual accounting rate of return for that year $($with calculations based on end$-$of$-$year total assets$).$ At the

moment, the Sydney Division generates cash revenues of $$1500000,$ incurs cash costs of $$900000$ and

annual depreciation of $$200000,$ with an investment in assets of $$9900000.$

New technology has recently been developed to build custom cases that eliminate wasted space. This new

technology would allow the Sydney Division to expand into making cases for the aviation industry. The

manager estimates that the new technology will require an investment in working capital of $$65000.$

Because the company already has a facility, there would be no additional rent or purchase costs for a

building, but the project would generate an additional $$190000$ in annual cash overhead. Moreover, the

manager expects annual materials cash costs for the expansion to be $$700000$ and labour to be about

$$450000.$

The management accountant of Armstrong estimates that the expansion would require the purchase of

equipment with a $$2300000$ cost and an expected disposal value of $$400000$ at the end of its seven$-$year

useful life. Depreciation would occur on a straight$-$line basis.

The management accountant of Armstrong determines the company$$s cost of capital as $6\%.$ The

management accountant$$s salary is $$160000$ per year; the expansion will not change that. The CEO asks

for a report on expected revenues for the project, and is told by the Marketing Department that it might

be able to achieve cash revenues of $$1750000$ annually from the aviation industry. Armstrong has a tax

rate of $30\%.$

Required

$1.$ Describe the five stages of the capital budgeting process for this expansion project.

$2.$ Separate the cash flows into four groups: $($a$)$ net initial investment cash flows; $($b$)$ cash flows from

operations; $($c$)$ cash flows from terminal disposal of investment; and $($d$)$ cash flows not relevant to the

capital budgeting problem.

$3.$ Calculate the NPV and IRR of the expansion project and comment on your analysis.

$4.$ What is the payback period on this expansion?

$5.$ Calculate the overall AARR $($based on average investment$)$ of the new technology.

$6.$ Comment on the impact that the investment will have on the manager$$s bonus over the course of

the seven years.

$7.$ Without doing any calculations, comment on the effect on the payback period and the NPV of:

a$.$ a decrease in the estimated salvage value from $$400000$ to $$100000$

b$.$ a change in the tax rate from $30\%$ to $40\%.$