Capital Budgeting Case -
This case is about the purchase of long-term operational assets which called capital investments. Investment in capital assets normally can be covered only by using those assets. Once a company purchases a capital asset, it is committed to that investment for an extended period of time. Business profitability ultimately hinges, to a large extent, on the quality of a few key capital investment decisions. A capital investment decision is essentially a decision to exchange current cash outflows for the expectation of receiving future cash inflows. Managers can choose from numerous analytical techniques to help them make capital investment decisions. Each technique has advantages and disadvantages. This case deals with the concept of time value of many, and using the net present value technique.
Steps:
1- Determine the initial investment (cost of the new project, initial cash outflows...etc)
2- Determine the annual net cash inflows
3- Calculate the present value of each cash flow, using appropriate discount rate
4- Calculate the net present value
5- Make the decision
The manager of Abu Dhabi Inc. is thinking of combining a new robot system with the current automated system. The following data related to the new system:
1- The cost of purchasing and installing the new system amount of $10,000,000
2- The system requires keeping a working capital (inventories of spare parts) $500,000
3- The cost of the system will be obtained through a 6-year 5% loan from Abu Dhabi National Bank. The loan and its interest will be paid in 6 annual installments.
4- The useful life of the new system is 20 years and will be sold then for $300,000
5- The annual sales from operating the new system is expected to be 10,000 units in the first 10 years and by 35,000 units in the last 10 years. The selling price is constant at $300 per unit.
6- Cost of goods sold is constant at $200 per unit
7- Annual operating expenses related to the new system:
Selling expenses $400,000
Administrative expenses $150,000
Depreciation expenses $485,000
Other expenses $ 50,000
If required rate of return is 12% and NPV model is used, should this project be accepted? Why?