ACCOUNTING BASED CASE STUDY

Accounting based case study

Accounting based case study

Q1. Calculate NPV and Payback Period. Explain any assumptions you made. According to TBC's usual decision criteria, would the AL II be purchased now?

Extractions from the Case:

AL-II:

Cost $345,000

Fixed cost $50,000

Scrap value $30,000

Useful Life 10 years

Required rate of return 15%

Payback Period 05 years

Old Crane:

Cost $195,000

Book Value $10,981

Scrap Value $5,000

Market Value $20,000

Maintenance cost $50,000

Useful Life 10 years

Fixed cost $40,000

Cost of Lost work $15,000

Fixing cost 10,000

NPV Calculation:

Cost of Capital: 15%

Initial Investment: $345,000

Annual Fixed Cost: $50,000

Annual Savings (Opportunity Cost): $25,000

New Jobs: $30,000 annually

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

Total

Cost

345,000

-

-

-

-

-

-

-

-

-

-

345,000

Fixed Cost

50,000

50,000

50,000

50,000

50,000

50,000

50,000

50,000

50,000

50,000

50,000

550,000

Savings

25,000

25,000

25,000

25,000

25,000

25,000

25,000

25,000

25,000

25,000

25,000

275,000

New jobs

60,000

60,000

60,000

60,000

60,000

60,000

60,000

60,000

60,000

60,000

60,000

660,000

The first criterion we will use to evaluate the capital project is Net Present Value. Net Present Value (NPV) is the total net present value of the project. It represents the total value added or subtracted from the organization if we invest in this project.

Assuming, every year two new job amounting $30,000 each would be won and by replacing old crane, $25,000 would be saved (Cost of Lost work $15,000 and Fixing cost $10,000). Required rate of return would be 15% according to the criteria set by TBC ltd.

According to above analysis, Net present Value comes out to be $34,783. Since, it is positive, the project should be taken.

Payback Period:

Assuming that the new machinery would yield $60,000 additional revenue and savings would be $25,000 annually.

Hence, the payback period for the new project would be 04 years.

Conclusion:

However, this method does not recognize the time value of money, we must consider the time value of money because of inflation, uncertainty, and opportunity costs.

According to the assumptions taken, both the above calculations would yield the positive decision for the TBC Ltd. Since, NPV is positive and Payback period is within the time line, the new machinery should be taken.

Q2. In the light of your calculations for the AL II purchase proposal, what would be the response to FS's comment that IRR of projects should be calculated?

Internal Rate of Return:

FS wants to incorporate IRR into project decision making. We will first elaborate and discuss IRR and its significance and limitations (Deterministic Models).

The discount rate often used in capital budgeting that creates the net present value of all cash flows from a particular project equal to zero. In general, the higher a project's internal rate of return, the more attractive it is to undertake the project. IRR can be used to rank several potential projects a firm is taking into consideration. Assuming all other factors are equal among the various projects, the project with the highest IRR would most likely be considered the best and undertaken first (Bruce, 2003).

You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong ...