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Respected Sir,
I have a small doubt with Capital Budgeting (Investment Appraisal) chapter.
Ques –
A company is considering a new project with a three year life producing the following costs and revenues :
Cost of Machine – $100,000
Depreciation of Machine – $20,000 p.a
Residual Value of Machine – $ 40,0000
Annual cost of Direct Labour – $20,000
Annual charge for foreman (10% apportionment) – $5,000
Annual cost of components required – $18,000
Annual net revenues from Machine – $80,000
Cost of Capital – 20%Now I do remember from your lectures that we take only the operational cashflows which are Revenues after deducting the Costs, and discount them.
Over here as per the answer only the annual cost of direct labour and cost of components are deducting from Revenue of $80,000.
Why aren’t we deducting the foreman cost ?
Also what does cost of ‘components’ mean over here. What are the ‘components’ exactly ?I do apologize if my doubts sound a bit stupid but asking them is the only way I actually remember things rather than simply looking at the answer and mugging up the method to do it. 🙁
The foreman is like a supervisor and because they are charging a share of his wages for profit purposes, does not mean that he will be paid more in total if they do this project. When doing NPV calculations we are only concerned with extra costs.
Components are the materials that are being used for producing whatever it is they are selling.
No. We are interested only in incremental (i.e. extra) costs.
If the supervisor were to be paid more as a result of doing the project, then the extra payment would be relevant.
But sir wont that mean that if we go ahead with this project, only then we will be needing the foreman (supervisor) for the labourers involved in doing this project ? Therefore isn’t that an incremental cost as well ?
No – all the question says is that the cost has been apportioned (shared). That means that they have shared part of the cost to this project for profit purposes, but it does not mean that the total cost of the foreman has increased. The total paid to the foreman will be the same with or without the project.
Partly making sense sir, please do forgive me for pestering you further,
So 10% of the foreman’s salary is being shared to this project for ‘profit purposes’
This is exactly what I’m unable to catch and therefore not understanding why we are not deducting it.Can you please explain the theory behind sharing a foreman’s wages with this project. And what exactly do we mean for profit purposes ?
By theory i mean, what is meant by ‘sharing’ a foreman’s wages with ‘this’ project.
If part of his wages are being shared with this project for profit purposes, im assuming profits associated by going ahead with this particular project. Therefore isn’t that a cost to be considered as well before you go ahead with this project ?
The foreman is paid a fixed $50,000 whether or not they go ahead with the project.
You will know from earlier lectures that we can apportion fixed overheads between different products or projects in order to look at the profitability of different products or projects.
Discounted cash flow calculations are only concerned with the cash flows – not with the profits. There is no extra cash paid to the foreman if they do within project.
(I assume that you are watching my free lectures? They are a complete free course for Paper F2 and cover everything needed to be able to pass the exam well.)
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