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- 12 Marks
Question
a) Bee Ltd manufactures high-quality mobile phones for its local market. Due to less competition, Bee Ltd sales have grown significantly over the past few years and are expected to grow. Bee Ltd is planning to launch a new model, ‘Ohenewa’.
The company has already spent GH¢1 million on Research and Development and will require a further investment of GH¢5.5 million in production equipment. This cost excludes the GH¢1.1 million installation fee. The project has a life span of five years. In the end, the equipment will have a residual value of GH¢0.6 million. Sales and production of Ohenewa over its lifecycle are expected to be:
| Year | Units |
|---|---|
| 1 | 6,500 |
| 2 | 7,500 |
| 3 | 8,000 |
| 4 | 7,800 |
| 5 | 7,000 |
The selling price in Year 1 and Year 2 will be GH¢750 per unit. However, the selling price will be reduced to GH¢600 per unit in Year 3 and will remain at this level for the remainder of the project. The variable cost as a percentage of sales is 55% over the entire product lifecycle. The fixed overhead, including depreciation cost expected to be incurred directly due to increasing the production capacity, is GH¢2 million per annum.
Other information:
- A cost of capital of 12% per annum is used to evaluate projects of this type.
- Bee Ltd has a history of accepting similar projects which pay back within three years.
- Ignore inflation and taxation.
Required:
i) Calculate the Payback Period for the Ohenewa project. (10 marks)
ii) Evaluate the acceptability of the project based on the calculation in i) above. (2 marks)
Answer
i) Payback Period Calculation:
| Year | Net Cash Flow (GH¢) | Cumulative Cash Flow (GH¢) |
|---|---|---|
| 0 | (6,600,000) | (6,600,000) |
| 1 | 1,393,750 | (5,206,250) |
| 2 | 1,731,250 | (3,475,000) |
| 3 | 1,360,000 | (2,115,000) |
| 4 | 1,306,000 | (809,000) |
| 5 | 1,690,000 | 881,000 |
Payback Period = 4 years + 809,0001,690,000×12\frac{809,000}{1,690,000} \times 12 months = 4 years 5 months
(10 marks)
ii) Evaluation:
The project should be rejected as the payback period of 4 years 5 months is more than the company’s acceptable payback period of three years. (2 marks)
Workings:
- Annual Depreciation:
Depreciation=6,600,000−600,0005=GH¢1,200,000\text{Depreciation} = \frac{6,600,000 – 600,000}{5} = GH¢1,200,000
- Net Cash Flows:
- Year 1: (6,500×GH¢750)×0.45−GH¢800,000=GH¢1,393,750(6,500 \times GH¢750) \times 0.45 – GH¢800,000 = GH¢1,393,750
- Year 2: (7,500×GH¢750)×0.45−GH¢800,000=GH¢1,731,250(7,500 \times GH¢750) \times 0.45 – GH¢800,000 = GH¢1,731,250
- Year 3: (8,000×GH¢600)×0.45−GH¢800,000=GH¢1,360,000(8,000 \times GH¢600) \times 0.45 – GH¢800,000 = GH¢1,360,000
- Year 4: (7,800×GH¢600)×0.45−GH¢800,000=GH¢1,306,000(7,800 \times GH¢600) \times 0.45 – GH¢800,000 = GH¢1,306,000
- Year 5: (7,000×GH¢600)×0.45+600,000−GH¢800,000=GH¢1,690,000(7,000 \times GH¢600) \times 0.45 + 600,000 – GH¢800,000 = GH¢1,690,000
- Tags: Capital Budgeting, Investment Appraisal, Payback Period, Project evaluation
- Level: Level 2
- Topic: Discounted cash flow
- Series: NOV 2021
- Uploader: Dotse