Question 3 Capital Investment Analysis

Assume the following data for a proposed investment in new equipment by a company. The company has the goals set out below before it will accept the project. The cash flows include variable labour costs and relates to a new business for the company. It is expected that the business will last 5 years and employees would be transferred to other divisions after the five years at the same manufacturing location and use their acquired skills to keep the general business growing. Employees will have to be recruited. The company reports profits to investors annually and the investors desire a 35% return on assets but the board also needs a positive net present value and payback of less than 4 years.

Questions:

1. What is an important strategic consideration in making the above decision? (1 mark)

2. Use quantitative analysis to assess whether the company should accept the project respecting the desires of investors and the board. (12 marks)
   1. Net present value analysis
   2. Payback period
   3. Average accounting return

3. What is one advantage and one disadvantage of the net present value method? (2 mark)

400,000 5 10% Cost of Equipment Project Life (years) Desired Return Estimated Cash Flows Year 1 Year 2 Year3 Year 4 Year 5 140,000 120,000 100,000 80,000 80,000 Discount Factor 0.909 0.826 0.751 Fill in 0.621 Goals Positive Net Present Value Average Cash Flows 104,000 4 years payback Average Equipment Average Accounting Profits 200,000 80,000 35% return