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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

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 companys cost of capital as 6%. The
management accountants 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 managers 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%.
BE SURE TO DO ALL CALCULATIONS

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