Capital budgeting
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The accountant of your business has recently been taken ill through overwork. In his absence his assistant has prepared some calculations of the profitability of a project, which are to be discussed soon at the board meeting of your business. His workings, which are set out below, include some errors of principle. You can assume that the statement below includes no arithmetical errors.
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You ascertain the following additional information:
- the cost of equipment contains #100,000, being the carrying (balance sheet) value of an old machine. If it were not used for this project it would be scrapped with a zero net realisable value. New equipment costing #500,000 will be purchased on 31 Dec Year 0. You should assume that all other cash flows occur at the end of the year to which they relate.
- the development costs of #90,000 have already been spent
- Overheads have been costed at 50 per cent of direct labour, which is the business's overheads are likely to amount to #30,000 a year.
- the business's cost of capital is 12 per cent.
Ignore taxation in your answer.
Required:
(a) Prepare a corrected statement of the incremental cash flows arising from the project. Where you have altered the assistant's figures you should attach a brief note explaining your alterations.
(b) Calculate:
(i) The project's payback period
(ii) The project's net present value as at 31 Dec Year 0
(c) Write a memo to the board advising on the acceptance or rejection of the project.
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Solution Summary
The solution explains the calculation of incremental cash flows, payback period and the NPV for the project.
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