- Explain how Annual worth, Present worth and Internal Rate of Return (IRR) are used in capital investment decisions.
Organisation has a contract to supply 5000 units per year with a contract sale price of $3 for each item. Determine which is the best option after-tax analyses using a tax rate of 30% and a minimum attractive after-tax rate of return of 10% and straight-line depreciation. Assume each alternative has a life of 6 years and 5% of original price as salvage value after end of the life. Use each of the following methods:
(a) Annual worth.
(b) Present worth.
(c) Internal Rate of Return (IRR).
2.What are the conventional and modified Benefit to Cost ratios and how these are used in capital investment decisions. Check in your workplace where equipment can be replaced by alternative brand with different price to buy and/ or different salvage value/ resale value/ disposal cost at the end of life, might have different cost to operate due to different energy rating, power consumption, spare parts etc. and different capacity/ production rate and/ or quality resulting different price of products from alternative options.
Alternatively consider that two alternative machines will produce the same product, but one will produce higher quality items which can be expected to return greater revenue.
- Your company has to obtain some new production equipment to be used for the next ten years, and leasing is being considered. You have been directed to perform an after-tax study of the leasing approach. The data information for the study is as follows:
Lease cost: First year, $80,000; second year, $60,000; third through ten years, $50,000 per year. Assume that a 10-year contract has been offered by the lessor that fixes these costs over the 10- year period. Other costs (ouside the contract) are $4,000 per year. The effective income tax rate
1- Develop the Annual After-tax Cash Flow (ATCF’s) for the leasing alternative.
2- If the Minimum Attractive Rate of Return (MARR) after taxes is 10%, what is the equivelant annual cost for the leasing alternative?
4.Machine X has been used for 10 years and currently has a book value of $20,000. A decision must be made concerning the most economic action to take: keep X, replace X with Y or replace X with Z. A before-tax analysis is to be performed.
If machine X is continued in service, it can be used for 10 years and scrapped at zero value. Annual operating and maintenance costs will equal to $90,000.
If machine X is replaced with machine Y, a trade-in allowance of $20,000 will be provided for X. The original purchase price for Y, excluding the trade-in allowance, is $120,000. At the end of the 10 year planning horizon, Y will have a salvage value of $30,000. Annual operating and maintenance costs will total $70,000.
If machine X is replaced with machine Z, no trade-in allowance will be provided for X. The purchase price for Z is $160,000. At the end of the 10-year planning horizon, Z will have a salvage value of $50,000. Annual operating and maintenance costs will total $60,000.
5.For this assignment students will be expected to present grammatically correct work thatcontains reasoned arguments. Students should demonstrate that they have read and understood the study material. In total, the submissions for this assignment should amount to between 1000 and 1500 words.
Answer to Question 1
The annual worth of the company represents the annual equivalent value of all cash inflows and cash outflows of the alternatives options (2). This method is usually used for making comparison between the viability of two projects. In this method only one life cycle of the project is to be evaluated. Present worth is used to estimate the future cash inflows from a project and is normally used in capital budgeting techniques. Internal Rate of Return is the rate at which the present value of the cash inflows and cash outflows becomes zero (4).
Capital Investment decision are often based on the analysis of Annual Worth, Present Worth and Internal rate of return. The annual worth of the projects helps the business in making comparison between alternative projects with the proposed projects. The present worth of the project is used by businesses to determine the present value of cash inflows which the business can expect from the project (3). The IRR of the project determines the minimum rate of return which the company needs to earn. These are important factors which are needed to be considered while taking investment decisions.
Answer to Question 2
The benefit/cost method is used by business in which the magnitude of benefits which can be derived from an alternative is compared with the magnitude of cost. It is denoted by B/C. A conventional B/C analysis is used generally in Government projects (1). In case of Modified benefit/cost method the annual operating and maintenance cost are deducted from the annual benefits which arises from the project. Both Modified and Conventional Method of computing benefit to cost ratio have significance in capital investment decisions. The benefit cost ratio is used to measure the benefits which are associated with the project with the cost which are associated with the project. If benefit cost ratio of a project is greater than 1 than the net present value of the cash inflows is more than the net present value of cash outflows of the project. The computation of the B/C analysis for the two machinery is shown below:
Answer to Question 3
Computation of MARR, NPV and Equivalent Annual Cost
Answer to Question 4
The above images show the calculations of NPV, MARR and Equivalent Annual Cost for the three options of machine which the company has which are Machine X, Machine Y and Machine Z. The NPV analysis of the three options are in negative which represents the costs of the machine and analysis of such costs are based on such costs. The above calculations reveals that the Machine Z is the most favorable option which is available to the company as the NPV of the cash outflows is lowest which is -$ 4,63,088.
Answer to Question 5
The main purpose of this assignment is to analyze the projects selection process of ABC ltd which is engaged in manufacturing activities. The company is planning to further expand the business and thereby needs to invest in a machinery for which the management of the company has options. For the purpose of selection of the options, the management will be applying capital budgeting techniques which will be involving NPV analysis, payback period analysis, profitability index analysis. The assignment also be commenting on the gaps which are there in Life cycle costing technique and will also be recommending to ABC ltd as to how the business can assess its risks better and improve the cost/benefit analysis of the business.
Gaps in Life Cycle Costing
Life cycle cost is a cost process which considers the actual cost and revenues which are attributable to a product from the first use of the product till the product becomes obsolete. In other words, life cycle cost technique follows the cost which are associated with the product over the years or in other words over the life cycle of the project. the total cost of the product involves all the costs which are costs which are related to planning, design, acquisition and support costs and any other costs which are related to the product (5). Life cycle costing represents the total cost of ownership in case of an asset and similarly will be including all the costs which will be incurred over the life time of the asset. The method allows businesses to consider all the costs which are incurred by the machinery for acquisition, maintenance, reimbursement or disposal when the business wants to take a decision. In other words, life cycle costing method for an asset considers the full cost implication of the asset before taking any decisions. The basic difference between traditional method of costing and life cycle costing lies in time period for which cost is considered. In case of traditional system of costing, costs are considered on the basis of calendar year whereas in life cycle costing method, the cost and revenues which are associated with the asset or product is traced through several calendar year which shows that life cycle costing is a longer process and is much more wide.
Thus, from the above discussions it is clear that life cycle costing approach is carried out by business so as to get a clear picture of the long-term picture of the cost and revenues associated with the project. The advantage of using this costing method is that it enhances control of the business over manufacturing costs. In addition to this, it is essential because it keeps a track and measure of the costs of the product or asset at different stages of life of the asset. In the case of ABC ltd, the company wants to implement life cycle costing techniques for the ascertain and monitoring the costs which are associated with asset over the useful life of the asset (6). However, there are certain gaps which are present in the life cycle costing technique which are mentioned below in points form:
- The technique of product life cycle costing spreads the expense or cost related with the asset over the useful life of the asset which might not be accurate as initial cost which are incurred on the asset at beginning of its life might be less than what the expenses are incurred on the asset towards the end of the useful life of the asset.
- It is important to monitor the continuous performance of the asset after implementation of life cycle costing techniques as if proper monitoring is not maintained than the costs associated with the asset will become more than the benefits.
- In case a business takes loan for purchase of asset and as per life cycle costing the loan amount will be repaid over the useful life of the asset which means the company would have to bear interest charges over the useful life of the asset which might not be a good option.
- The technique of life cycle costing assumes that the performance of the assets which is in the initial years will not be same as the performance of the asset in the later years of the useful life of the asset. This concept is not appropriate as such might not be the case and therefore the costs assumption of the business might not be realistic
The above mention points are the various limitation or gaps which the techniques Life cycle costing faces in comparison to traditional and other costing techniques.
The recommendations which can be given to the company for improving benefit/cost analysis and risks of the business are given below:
- The business needs to implement a proper capital structure so as to reduce the cost of capital which signifies risks which are associated with the capital structure of the business. The business needs to incorporate debt capital and equity capital in the capital mix so as to attain a favorable balance in the capital structure.
- The management of the company needs to conduct NPV analysis so as to ensure that the assets which the management of the company intends to invest on has benefits which exceeds the cost which is related to the asset. The management of the company
- The management needs to analyze the risks which are associated with the asset so as to ensure that the risks which are associated with the business does not exceeds the returns which are expected from an investment.
- Marglin SA. Public Investment Criteria (Routledge Revivals): Benefit-Cost Analysis for Planned Economic Growth. Routledge; 2014 Oct 17.
- Kogan A. The criticism of net present value and equivalent annual cost. Journal of Advanced Research in Law and Economics. 2014 Jul 1;5(1 (9)):15.
- Guinot J, Evans D, Badar MA. Cost of quality consideration following product launch in a present worth assessment. International Journal of Quality & Reliability Management. 2016 Mar 7;33(3):399-413.
- Rich SP, Rose JT. Re-examining an old question: Does the IRR method implicitly assume a reinvestment rate?. Journal of Financial Education. 2014 Apr 1:152-66.
- Azmat M. LIFE CYCLE COSTING.
- Martinez-Sanchez V, Kromann MA, Astrup TF. Life cycle costing of waste management systems: Overview, calculation principles and case studies. Waste management. 2015 Feb 1;36:343-55.