Project Appraisal: Applications of NPV

1. Project Appraisal: Applications of NPV Corporate Finance 6

2. Project appraisal: applications of NPV • The replacement decision/the replacement cycle • The calculation of annual equivalent annuities • The make or buy decision • Optimal timing of investment • Fluctuating output situations

3. The replacement decision • Amtarc plc produces Tarcs with a machine which has a useful life of four more years before it will be sold for scrap, raising £10,000. • Q-2000 cost of £800,000 payable immediately. • Existing machine secondhand value: £70,000. • The Q-2000 will have a life of four years before being sold for scrap for £20,000. • Q-2000 has lower raw material wastage and its reduced labour requirements. • Selling price and variable overhead will be the same as for the old machine.

4. Amtarc: accountant’s figures • Q-2000 reduces raw material buffer stocks by £120,000. • Redundancy payments of £50,000 will be necessary after one year. • The required rate of return is 10 per cent. • To simplify the analysis sales, labour costs, raw material costs and variable overhead costs all occur on the last day of each year.

5. Amtarc plc • Required: • Using the NPV method decide whether to continue using the old machine or to purchase the Q-2000. • Note the irrelevant information: • Depreciation is not a cash flow • The book value of the machine is merely an accounting entry

6. NPV Incremental cash flow table

7. Replacement cycles

8. Replacement cycles (continued)

9. Replacement cycles: present values

10. Replacement cycles: annual equivalent annuity PV or A = PV = A × af af –£9,845.98 Three-year replacement: = –£3,959.14 A = 2.4869

11. Replacement cycles: AEAs

12. When to introduce a new machine

13. When to introduce a new machine (continued)

14. Timing of projects

15. The make or buy decision • Davis and Davies plc • Buy in the ‘eyes’ for the rods at £1 per set • Use 100,000 sets per annum • To produce their own ‘eyes’ • Spend £40,000 immediately on machinery etc. • Machinery will have a life of four years • Annual cost of production of 100,000 sets will be £80,000, £85,000, £92,000 and £100,000 respectively • Bought-in components estimates are £105,000 for year 1, followed by £120,000, £128,000 and £132,000 for years 2 to 4 respectively, for 100,000 sets per year • New machinery will be installed in an empty factory the open market rental value of which is £20,000 per annum • The firm’s cost of capital is 11 per cent

16. The make or buy decision (continued)

17. Fluctuating output • Potato Sorting Company • Summer and autumn: its two machines work at full capacity, which is the equivalent of 20,000 bags per machine per year • In the six months of the winter and spring the machines work at half capacity • Operating cost of the machine per bag is 20 pence • Very long productive life, yet no secondhand value • Fastsort has an identical capacity to the old machine but its running cost is only 10 pence per bag • Productive indefinitely • Cost £12,000 each to purchase and install

18. Production manager’s plan to replace with 2 Fastsorts

19. Production manager’s plan to replace with 2 Fastsorts (continued)

20. Replacing only one old machine

21. Lecture review • The replacement decision • Annual equivalent annuities (AEA) • Optimal replacement cycle • Whether to repair or buy a new machine • Timing of projects • Fluctuating output • Make or buy decision