Problem
1. Ball Limited is a small independently-owned food processing company which operates a factory producing microwavable meals. Annual production of its "Gourmet" range is given in the following table:
|
|
Year 1
|
Year 2
|
Year 3
|
Year 4
|
|
Actual production (units)
|
600,000
|
680,000
|
720,000
|
700,000
|
The owner of Ball Limited wants to retire at the end of four years, with all production being closed down. Despite the upcoming retirement in four years' time, the company must replace the existing equipment now which makes the Gourmet range because of reliability problems. Managers are considering two options:
The purchase of equipment P or the rental of equipment Q.
Information on these two options is given below:
|
|
Equipment P
|
Equipment Q
|
|
Variable cost per meal ($)
|
2.60
|
3.80
|
|
Annual fixed cost ($)
|
55,000
|
15,000
|
|
Initial cost ($)
|
2,500,000
|
-
|
|
Annual rent cost ($)
|
|
18,000
|
Additional relevant information has also been made available:
a) Equipment P would have to be paid for immediately, while all other cash flows would be expected to occur at the end of each year. Equipment P would have a four-year life with a scrap value of $45,000.
b) Equipment Q annual rental cost payments are made in advance at the start of each year of use.
c) Annual fixed costs directly relate to each investment project.
d) Managers have chosen an 8% discount rate in the appraisal of the equipment options.
Task
a) Calculate the present value of the net cash outflows incurred by equipment P and Q using the 8% discount rate chosen by Ball Limited. Use your results to recommend whether equipment P or Q should be chosen.
2. The chefs at Ball Limited are working on a new range of meals to exploit a short-term gap in the market. With the upcoming closure of the company, this range of meals is only expected to have a four-year life and generate annual net cash inflows of $125,000. The necessary production facilities are expected to cost $300,000; this would have to be paid for at the start of production and sales, while all other cash flows would be expected to occur at the end of each year. After four years, zero scrap value is expected from the liquidation of this investment proposal.
Task
a) Assuming that a 14% discount rate is appropriate for the development of this new range of meals, estimate the net present value (NPV) of the investment proposal.
b) If the finance director of Ball Limited has estimated the NPV of this new range of meals to be $23,500 using a 20% discount rate, calculate its internal rate of return (to 1 decimal place).
3. Despite the superiority of NPV as an investment appraisal technique, payback period continues to be a popular method of deciding on whether investment projects are acceptable.
a) Briefly discuss the reasons why payback period is often preferred as an investment appraisal technique, and also its limitations.