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Hello,
Would appreciate if any of you could help clarify or explain to me on why is my test answer wrong for this NPV question. Will be retaking the same test paper which is why I need to know whats wrong. Thanks!
Motor pte has developed a new product for sale. An additional fixed costs of production (without depreciation) is estimated to be $150,000 per year. Motor pte estimated that the product will sell 140,000 units a year over the next five years. The sale price will be $6 per unit & variable cost are $4 per unit.
To develop the product, machinery priced of $500,000 is required. The salvage value of the machine is estimated to be $80,000 in five year times. The company uses the straight-line method of depreciation. The cost of capital is 15%. Ignore taxation.
1. Calculate the NPV of the product.
2. The discount rate (Use the method of interpolation with r values of 15% & 20%.)
3. Initial outlay of the machinery
4. Residual value of the machinery
5. DurationMy answer:
1. No cashflow given.
Depreciation: (500,000 – 80,000)/4 = 105,000
Net contribution: 140,000 units x $2 = 280,000 (Ignore taxation)
150,000(fixed cost) + 280,000 + 105,000 = 535,000-500,000 + 535,000/(1.15)1 + 535,000/(1.15)2 + 535,000/(1.15)3 + 535,000/(1.15)4 + 615,000/(1.15)5 = 1,333,177.12
Decision: Accept.
2. IRR method
r value = 15%
0 = -(500,000) + 535,000/(1.15)1 + 535,000/(1.15)2 + 535,000/(1.15)3 + 535,000/(1.15)4 + 615,000/(1.15)5 = 1,333,177.12
r value = 20%
0 = -(500,000) + 535,000/(1.20)1 + 535,000/(1.20)2 + 535,000/(1.20)3 + 535,000/(1.20)4 + 615,000/(1.20)5 = 1,132,127.70
IRR = 15% + [1,333,177.12 / (1,333,177.12 + 1,132,127.70)] x (15 – 20) = 9.73
IRR = 20% + [1,132,127.70 / (1,132,127.70 + 1,333,177.12)] x (20 – 15) = 22.3
3.
N = 5
I = 15%
IO = PV (CFs)
IO = 130,000 (1.47) = 191,1004. blank
5. Payback period method
280,000 – 150,000 = 130,000
3 years + (280,000 – 150,000) / 130,000 = 4 years.Also if possible, can anyone provide the correct working/ answer? So that I can compare them with my incorrect working. Thanks!
1. The cash inflow year is the contribution (280,000) less the additional fixed costs (150,000) and so is 130,000 per year. (I have no idea why you have added the fixed costs – they are an outflow and so reduce the net inflow each year).
Depreciation is not a cash flow and so is irrelevant when calculating the NPV.2. For the IRR, again you have used the wrong cash flows (see (1)).
Even if your cash flows were correct, your ‘formula’ is wrong. Given that both NPV’s you have calculated are positive, then the denominator should have been (1,333,177.12 – 1,132,127.70) – you were wrong to add them.
There cannot be 2 IRR’s for a project with these cash flows!!3. The initial outlay for the machine is given in the question – it is $500,000 !!
It seems a strange thing for the question to have asked – are you sure that is exactly what it asked for?4. The residual value again is given in the question – it is the salvage value of $80,000.
5. The exam won’t use the word ‘duration’ (in later exams this actually means something else). However as payback period, you are now using the correct cash inflow of 130,000 per year. The initial outflow is 500,000, and so the payable period is 500,000/130,000 = 3.85 years.
Finally, although it is OK to discount using first principles as you have done, why on earth do you not save time and use the present value discount factors that are given to you in the exam?
I really do suggest that you watch my free lectures for Paper F9 (which is now called Paper PM). The lectures are a complete free course and cover everything needed to be able to pass the exam well.
Hello. Missed out a sentence which is why the questions looked so weird. So sorry about it.
By right it should be
1. Calculate the NPV of the product.
2. Undertake sensitivity analysis to show by how much the following factors would have to change before the product ceased to be worthwhile:
A. The discount rate (Use the method of interpolation with r values of 15% & 20%.)
B. Initial outlay of the machinery
C. Residual value of the machinery
D. DurationFor (1), I have already answered you.
For (2) you need to watch my free lectures on ‘risk and uncertainty’, because I work through a very similar example.
The lectures are a complete free course for Paper F9 (which is now called FM) and cover everything needed to be able to pass the exam well.
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