Period and Product cost for Accounting?

How to Calculate Net Present Value, Internal Rate of Return & Accounting Payback Period for multiple projects?

• Company A is considering investing in a new bottling plant for a product which is expected to sell 100,000 bottles in the coming year. Market research indicates that unit sales will increase by 12% per annum in years 2,3,4 and 5 whilst selling prices and costs are expected to remain constant at $40.50 and $32.40 per unit respectively. The new plant is expected to cost $3,400,000 plus an additional $100,000 for working capital. At the end of the five years the plant could be sold for $450,000. An alternative has been suggested that would mean unit sales would increase by 20% per annum in years 2,3,4 and 5 with unit costs and revenues remaining the same. The capital investment for this project would amount to $4,000,000. The plant would be sold at the end of the five years for scrap value of $90,000. The company has a cost of capital of 10%. Show working for Net Present Value, Internal Rate of Return & Accounting Payback Period for both projects.

• Answer:

  Option #1: First, lay out your cash flows: #0: investment (3,400,000) + Net Working Capital Investment aka "InvNWC" (100,000) = (3.5m) Assuming your sales are all cash: unit profit: 40.50 - 32.40 = $8.10 Cash flow from sales: year 1: 100,000 * 8.10 = 810,000 Yr. 2: 810,000 * 1.12 = 907,200 Yr 3: 907,200 * 1.12 = 1,016,064 Yr 4: 1,016,064 * 1.12 = 1,137,991.68 Yr 5: 1,137,991.68 * 1.12 = 1,274,550.68 Other cash flows.... Since the problem does not mention depreciation or a tax rate, we'll assume the cash flow (net) from the sale of the plant at the end of year 5 is $450,000. [Usually you would account for capital gain or loss, net of taxes. Example: book value at end of year 5: 400,000, sale price 450,000 less (50,000 * tax rate) = cash flow from sale. Additionally, the annual depreciation would provide a tax shield, and this shield would be accounted for in the annual cash flows.] Add'l yr 5 cash flows: 450,000 + return of InvNWC 100,000 So, total yr 5 cash flow = 450k + 100k + 1,274,550.68 from Ops = 1,824,550.68 Next, discount the cash flows by the cost of capital 10%. E.g. yr 1 CF/1.10, yr 2 CF/1.10^2, etc and "add" the negative CF0 cash flow of (3.5m) to get NPV. NPV = $659,665.68 IRR (I used an HP12c): 16.22% Accounting Payback Period: Starting with the CF0 of $3.5 million, start subtracting each year's cash flow.... 3.5m - [CF1] 810,000 = 2.690m - [CF2] 907,200 = 1,782,800 - [CF3] 1,016,064 = 766,736 < "balance" after 3 years of cash flows. Since your 4th year's CF exceeds this amount, you know that the project is paid back before the full fourth year. Divide the "balance" by the 4th year's cash flow to determine the % of the year it takes to finish the payoff: 766,736 / 1,137,991.68 = 0.67376 of a year. So the total accounting payback period is 3.67 years. It's not clear whether Option #2 also has a InvNWC of $100k. Since it's not specifically stated, your CF0 is ($4m) CF1 = 810,000 CF2 = 810,000 * 1.20 and so on for CFOps. Add to the 5th CFOps the $90k from the sale of the plant. Follow the above steps - Discount the CFs for NPV, calc IRR, calc Acctg payback period as above. (If the InvNWC does apply, add it to the cost in CF0, and account for its recapture in year 5.) Investment Decision: Whichever project has the higher NPV is the project you should choose. FYI -Higher NPV trumps higher IRR. Hope this helps....