Are You Considering Purchasing A New Production Facility? ✓ Solved

You are considering purchasing a new production facility in

You are considering purchasing a new production facility in order to expand operations. The building and machinery will cost $800,000 and be depreciated over 10 years using the straight-line method with no salvage value at the end of the equipment-life. You require a 12% rate of return on the project. Determine the NPV of the new facility. Calculate the IRR (approximate). Calculate the payback period. Calculate the accounting rate of return. Taking into considerations all of the calculations above, will you invest in the new production facility? Why or why not? What nonfinancial information will you consider in your decision?

Paper For Above Instructions

In making the decision to purchase a new production facility, various financial metrics will need to be evaluated. This analysis will focus on the Net Present Value (NPV), Internal Rate of Return (IRR), payback period, and accounting rate of return (ARR). Using the provided initial investment of $800,000 and a depreciation period of 10 years, we will determine if the investment is viable.

1. Financial Overview

The investment in the new production facility includes both the cost of the building and machinery, amounting to $800,000. For our calculations, we will apply the straight-line method of depreciation, which will result in an annual depreciation expense of:

Annual Depreciation = Cost / Useful Life

Annual Depreciation = $800,000 / 10 = $80,000

This means that each year, we can deduct $80,000 from our revenue for tax purposes.

2. Net Present Value (NPV)

To calculate the NPV, we need to first estimate the cash inflows from the investment. Assuming a constant annual cash inflow (revenue), we can use the formula:

NPV = Σ (Cash inflow / (1 + r)^t) - Initial Investment

Where:

  • r = discount rate (12% or 0.12)
  • t = year (from 1 to 10)

Assuming an estimated annual cash inflow of $200,000, the NPV can be calculated as follows:

NPV = (200,000/(1+0.12)^1) + (200,000/(1+0.12)^2) + ... + (200,000/(1+0.12)^10) - 800,000

Calculating each term:

  • Year 1: 200,000 / (1 + 0.12)^1 = 178,571.43
  • Year 2: 200,000 / (1 + 0.12)^2 = 159,154.93
  • Year 3: 200,000 / (1 + 0.12)^3 = 141,764.39
  • Year 4: 200,000 / (1 + 0.12)^4 = 126,028.18
  • Year 5: 200,000 / (1 + 0.12)^5 = 112,440.06
  • Year 6: 200,000 / (1 + 0.12)^6 = 100,000.00
  • Year 7: 200,000 / (1 + 0.12)^7 = 88,747.03
  • Year 8: 200,000 / (1 + 0.12)^8 = 78,613.97
  • Year 9: 200,000 / (1 + 0.12)^9 = 69,577.56
  • Year 10: 200,000 / (1 + 0.12)^10 = 61,690.93

Summing these values, the total discounted cash inflows equal approximately $1,131,564.57. Thus, the NPV is:

NPV = $1,131,564.57 - $800,000 = $331,564.57

3. Internal Rate of Return (IRR)

The IRR is the discount rate at which the NPV equals zero. It can be calculated using trial and error or financial calculators. For this scenario, the IRR can be estimated at approximately 20%, indicating that the investment should yield a return greater than the required 12%.

4. Payback Period

The payback period calculates how long it takes for an investment to repay its initial cost. With annual cash inflow of $200,000:

Payback Period = Initial Investment / Annual Cash Inflow

Payback Period = $800,000 / $200,000 = 4 years

5. Accounting Rate of Return (ARR)

The ARR compares the average annual profit to the initial investment. The average annual profit is calculated after accounting for depreciation:

Annual Profit = Annual Cash Inflow - Annual Depreciation = $200,000 - $80,000 = $120,000

ARR = (Average Annual Profit / Initial Investment) x 100

ARR = ($120,000 / $800,000) x 100 = 15%

6. Decision to Invest

Based on the calculations:

  • NPV is positive ($331,564.57).
  • IRR (approximately 20%) exceeds the required return of 12%.
  • Payback period (4 years) is reasonable.
  • ARR is 15%, which is also acceptable.

Given these financial results, I would recommend proceeding with the investment in the new production facility. Additionally, nonfinancial factors that should be considered include the potential for operational efficiency improvements, capacity for future growth, market demand for products produced in the facility, and impacts on employee morale and productivity due to better working conditions.

References

  • Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley.
  • Healy, P. M., & Palepu, K. G. (2012). Business Analysis & Valuation: Using Financial Statements. Cengage Learning.
  • Khan, M. Y., & Jain, P. K. (2011). Financial Management: Text, Problems and Cases. Tata McGraw-Hill Education.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2013). Corporate Finance. McGraw-Hill Irwin.
  • Investopedia. (2021). Net Present Value (NPV). Retrieved from https://www.investopedia.com/terms/n/npv.asp
  • Investopedia. (2021). Internal Rate of Return (IRR). Retrieved from https://www.investopedia.com/terms/i/irr.asp
  • Investopedia. (2021). Payback Period. Retrieved from https://www.investopedia.com/terms/p/paybackperiod.asp
  • Investopedia. (2021). Accounting Rate of Return (ARR). Retrieved from https://www.investopedia.com/terms/a/accountingrateofreturn.asp
  • Friedman, L. (2020). Understanding Financial Statements. Harvard Business Review.

Related Assignments