Project a Involves Adding a New Component To The Car’s Emission Control System. At First It Will Only Be Available For Ford Automobiles And Then It Will Be Available For Other Models.

Question

Axis Corporation is planning for business expansion with investment in new projects manufacturing new and advanced spares for motor vehicle. The company is having two potential projects to be opted one is manufacturing of a new component to the emission control system of cars and the other is the manufacturing of air conditioning adaptor for the Ford and GM automobiles.

Accepted Answer

Product staff of the company have estimated the expected demand for the products and revenue arising from them for the next three years. It has been further estimated that, cost of goods sold would be 60% of the sales revenue. Therefore, before selecting an investment proposal from the available projects, the profitability and feasibility of the projects must be evaluated and analyzed. With the estimation of straight line depreciation, 30% tax rate and 14% discounting rate, following investment appraisal techniques can be applied for evaluation of the projects

Answer

It can be observed from the above analysis that, project A is having a net cash generated from operation of $45,600 in the first year and thereafter a significant increase in cash flow can be observed. It can be observed that the net present value of the project A is $43,887 and the internal rate of return is 31%. The discounted payback period is 2.44 years and it is having a profitability index of 1.37 with an accounting rate of return of 61.33%[ Harris, Elaine. Strategic project risk appraisal and management. Routledge, 2017.].

Answer

From the above discussion and analysis, it can be concluded that, thou both the project is having a positive net present value, project A is more feasible than the project B having a higher net present value. Though the internal rate of return is higher for the project B and the payback period is also lower, the project A will cause more capital accumulation than the project B. Hence, it can be recommended to select the project A for the investment.

Initial investment	$ 120,000
Life of the project (In years)	3
Tax rate	30%
Cost of goods sold	60%
Discounting rate	14%

Year	0	1	2	3
Sales revenue		$ 120,000	$ 170,000	$ 370,000
Cost of goods sold		$ (72,000)	$ (102,000)	$ (222,000)
Gross profit		$ 48,000	$ 68,000	$ 148,000
Depreciation expense		$ (40,000)	$ (40,000)	$ (40,000)
Profit before tax		$ 8,000	$ 28,000	$ 108,000
Provision for tax		$ (2,400)	$ (8,400)	$ (32,400)
Profit after tax		$ 5,600	$ 19,600	$ 75,600
Add: Depreciation		$ 40,000	$ 40,000	$ 40,000
Cash flow generated from operations		$ 45,600	$ 59,600	$ 115,600
Initial investment	$ (120,000)
Free cash flows	$ (120,000)	$ 45,600	$ 59,600	$ 115,600
Discounting factor	1.0000	0.8772	0.7695	0.6750
Discounted cash flows	$ (120,000)	$ 40,000	$ 45,860	$ 78,027
Cumulative cash flows	$ (120,000)	$ (80,000)	$ (34,140)	$ 43,887
Fraction in years				0.4375

Net present value (NPV)	$ 43,887
Internal rate of return (IRR)	31%
Discounted payback period	2.44
Profitability index (PI)	1.37
Accounting rate of return (ARR)	61.33%

Initial investment	$ 130,000
Life of the project (In years)	3
Tax rate	30%
Cost of goods sold	60%
Discounting rate	14%

Year	0	1	2	3
Sales revenue		$ 375,000	$ 130,000	$ 110,000
Cost of goods sold		$ (225,000)	$ (78,000)	$ (66,000)
Gross profit		$ 150,000	$ 52,000	$ 44,000
Depreciation expense		$ (43,333)	$ (43,333)	$ (43,333)
Profit before tax		$ 106,667	$ 8,667	$ 667
Provision for tax		$ (32,000)	$ (2,600)	$ (200)
Profit after tax		$ 74,667	$ 6,067	$ 467
Add: Depreciation		$ 43,333	$ 43,333	$ 43,333
Cash flow generated from operations		$ 118,000	$ 49,400	$ 43,800
Initial investment	$ (130,000)
Free cash flows	$ (130,000)	$ 118,000	$ 49,400	$ 43,800
Discounting factor	1.0000	0.8772	0.7695	0.6750
Discounted cash flows	$ (130,000)	$ 103,509	$ 38,012	$ 29,564
Cumulative cash flows	$ (130,000)	$ (26,491)	$ 11,520	$ 41,084
Fraction in years			0.6969	0.3897

Market price of preferred stock	$ 115.50
Face value	$ 100.00
Dividend rate	10%
Annual dividend	$ 10.00
Cost of preference share	8.66%

Face value of the bond	$ 1,000.00
Current price of the bond	$ 922.87
Capital yield	$ 77.13
Yield to maturity	8%
Present value of capital yield	$ 61.23
Net proceeds	$ 861.64
Coupon rate	5%
Annual interest	$ 50.00
Cost of bond	5.80%

Market rate	8%
Risk free rate	1.50%
Company 1	0.70
Company 2	0.80
Company 3	1.05
Company 4	4.00
Company 5	1.10
Average beta	1.53
Cost of equity using CAPM	13.74%

Current dividend	$ 2.07
Market price of the shares	$ 50.00
Dividend growth rate	5%
Cost of equity using dividend growth model	9.14%

Computation of weighted average cost of capital:

Source of capital	Amount	Cost	Weighted cost
Debt	300000	5.80%	3.5%
Equity and retained earnings	200000	13.74%	5.5%
Weighted average cost of capital			9.0%

Capital Budgeting Analysis of Two Investment Projects