Brown metals Ltd

CASE STUDY

Give your recommendations about the proposed investment

Particulars	Machine A (Rs. In lacs)	Machine B (Rs. In lacs)
1) NPV	12	14
2) Profitability index	1.48	1.35
3) Pay Back period	2 years	3  years
4) Discounted pay back period	3.18 years	3.21  years

 

It is advised to go in for Machine B with enhanced capacity, which will add more value to the firm. NPV is higher in respect of Machine B as compared to Machine A & therefore machine with higher NPV needs to be invested.

 

Ques 1: You are required to make these calculations and in the light thereof, advise the finance manager about the suitability, or otherwise, of machine A or machine B.

Solution:

Advise to finance manager of Brown metals ltd, to  select the appropriate machine:

Particulars	Machine A (Rs. In lacs)	Machine B (Rs. In lacs)
1) NPV	12	14
2) Profitability index	1.48	1.35
3) Pay Back period	2 years	3  years
4) Discounted pay back period	3.18 years	3.21  years

It is advised to go in for Machine B with enhanced capacity, which will add more value to the firm. NPV is higher in respect of Machine B as compared to Machine A & therefore machine with higher NPV needs to be invested.

Workings are as follows:

( a) to buy machine A which is similar to the existing machine :

Years	Cash flows (Rs. In lacs)	Unrecovered cash flows	Discount rate *  @10%	Discounted cashflows	Unrecovered discounted cash flows
(1)	(2)		(3)	(4) = (2) * (3)	(5)
0	(25)	(25)	1.000	(25)	(25)
1	-	(25)	0.909	-	(25)
2	5	(20)	0.826	4	(21)
3	20	-	0.751	15	(6)
4	14	14	0.683	10	4
5	14	28	0.621	9	12
NPV				12

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate   & n = year

1)  Net Present value = Present value of inflows - Present value of outflows = 12 (as computed above)

2)  Profitability Index = Present value of inflows / present value of outflows which should be  >1

 37 /  25    1.48

3)  Payback period = Base year + [(unrecovered cash flow of base year / cash flows of next year ) *12] where base year =  year in which unrecovered cash flows turns 0 or +ve

Payback period = 2 + [(20/0)*12]          = 2 years

4)  Discounted Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted cash flows of next year) *12] where base year =  year in which unrecovered cash flows turns 0 or +ve

Payback period = 3 + [(6/4)*12]

 =3.18 years

( b) to go in for machine B which is more expensive & has much greater capacity :

Years	Cash flows (Rs. In lacs)	Unrecovered cash flows	Discount rate *  @10%	Discounted cashflows	Unrecovered discounted cash flows
(1)	(2)		(3)	(4) = (2) * (3)	(5)
0	(40)	(40)	1.000	(40)	(40)
1	10	(30)	0.909	9	(31)
2	14	(16)	0.826	12	(19)
3	16	-	0.751	12	(7)
4	17	17	0.683	12	4
5	15	32	0.621	9	14
NPV				14

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate   & n = year

1)  Net Present value = Present value of inflows - Present value of outflows = 14 (as computed above)

2)  Profitability Index = Present value of inflows / present value of outflows which should be

>1

 54 /  40    1.35

3)  Payback period = Base year + [(unrecovered cash flow of base year / cash flows of next year ) *12] where base year =  year in which unrecovered cash flows turns 0 or +ve

Payback period = 3 + [(16/0)*12]          = 3 years

4)  Discounted Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted cash flows of next year) *12] where base year =  year in which unrecovered cash flows turns 0 or +ve

Payback period = 3 + [(7/4)*12]

 =3.21 years

 

 

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