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Question Al Part I (a) Your father is now aged 50 and plans to start saving for 15 years to accumulate $1,500,000 at the age of 65 as his retirement fund
Question Al Part I (a) Your father is now aged 50 and plans to start saving for 15 years to accumulate $1,500,000 at the age of 65 as his retirement fund. Given the required return is 9 percent compounded monthly, what will be his monthly payments with the first payment occurring one month from now? (5 marks) (b) Followed with the previous question in part (a), what will be his annual payments if your father makes an annual saving with the first payment starting from today? (6 marks) Part II Flamingo Inn has outsourced its laundry service to a contract cleaning company at an annual cost of $360,000. Now, due to escalating costs, Flamingo is considering performing the service itself by purchasing new washers, dryers, and presses at a total cost of 500,000. Compared to outsourcing, the Financial Controller expects average cash savings of $150,000 per year. The machines are expected to last for 5 years with no residual value. The desired rate of return is 10% for this project. Given: Present Value of an Annuity $1 per Period: Periods 10% 1 0.9091 2 1.7355 3 2.4869 4 3.1699 5 3.7908 6 4.3553 7 4.8684 8 5.3349 9 5.7590 To evaluate whether to undertake any capital budgeting project proposal, the company only carry out those projects that can get back its investment capital within 2 years.
Question Al (continued) Required: (a) Compute the payback period for the project and explain (within 10 words) whether it is acceptable or not. (3 marks) (6) Compute the NPV of the project and explain (within 10 words) whether the project is acceptable or not. (3 marks) (e) Consider the following scenarios separately by using NPV analysis: (1) Suppose the machines can only last for 4 years. Is this project acceptable and why (within 10 words)? (3 marks) (ii) Suppose, due to environmental health regulations, Flamingo has to spend an additional $10,000 cash to dispose all machines at the end of the year five. Is this project acceptable and why (within 10 words)? (3 marks) (iii) Based on an expected machines useful life of 5 years, what is the minimum annual cash savings required in order to justify the investment of this project? (3 marks) (d) In making capital budgeting decisions, why do we focus on cash flows rather than accounting profits? (within 80 words) (4 marks)
Expert Solution
Part 1
a) Interest rate per month = 9%/12 =0.0075
No. of months = 15*12 = 180
So, the monthly payment (A) required is given by
A/0.0075*(1.0075^180-1) = 1500000
=> 378.4058 * A = 1500000
A = 3964
Monthly payment will be $3964
b) Interest rate per annum = (1+9%/12)^12- 1 =0.093807 p.a. compounded annually
No of years = 15
So, annual payment (A) for 15 years starting today (annuity due) is given by
A/0.093807*(1.093807^15-1)*1.093807 = 1500000
=> 33.09214* A = 1500000
A = 45327.98
So, Annual payment will be $45327.98
PART II
a) Payback period = Initial Investment/ Annual Cost savings = $500000/$150000 = 3.33 years
As the company only accepts projects with payback period 2 year or less, this project is not acceptable as per this criteria
b) NPV = -500000+ 150000/1.1+150000/1.1^2+150000/1.1^3+150000/1.1^4+150000/1.1^5
=-500000+150000/0.1*(1-1/1.1^5) or -500000+150000*present value annuity factor at 10% for 5 years
=$68618.02 or -500000+150000*3.7908 = $68620
As the NPV is positive,the project is acceptable
c)
i) If the machine lasts only 4 years
NPV of machine = -500000+ 150000* present value annuity factor at 10% for 4 years
=-500000+150000*3.1699
= - $24515
As the NPV is negative,the project is NOT acceptable
ii) If $10000 has to be spent at the end of 5 years
NPV of machine = -500000+ 150000* present value annuity factor at 10% for 5 years - 10000/1.1^5
=-500000+150000*3.7908 - 10000/1.1^5
= $62410.79
As the NPV is positive,the project is acceptable
iii) Minimum Annual Cash savings (A) are those at which NPV = 0
-500000+ A/0.1*(1-1/1.1^5) =0
=> A*3.7908 = 500000
A = 131898.28 (actual figure is $131898.74)
So, Minimum Annual Cash savings required is $131898.74 to justify the investment
d) Capital Budgeting decisions are done using Cashflows as this are the actual amounts which are paid or received. Accounting profits are for maintaining books of accounts. Many times, due to depreciation allowances etc, actual cashflows are much different than accounting profits. Hence, the actual cashflows should be taken
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