Question: *Use Payback, Net-Present Value (NPV), and IRR to assess whether the investment in the new machines
Question:
Question: *Use Payback, Net-Present Value (NPV), and IRR to assess whether the investment in the new machines is warranted (assume a payback cut-off period of 7 years and use Company A weighted average cost of capital as the discount rate). Also, explain to the BoD the benefits of the NPV vis-a-vis other capital budgeting methodologies*
Case Study:
The marketing department is launching an aggressive 10-year marketing campaign whereby the payment period to wholesale customers is extended from 30 to 60 days, leading to (forecasted) increase in sales of 21,900 bikes per year. While the product (unit) is selling at $620/unit on average, Company A can purchase its material from its supplier at $300/unit and is liable to pay its supplier in 60 days on average. Manufacturing and selling the units takes a total of 25 days on average. To accommodate the increase in demand due to the campaign, company A would need to buy new machines costing $16,000,000 today, with a lifetime of 10 years (assume straight-line depreciation and 'zero' salvage value). Moreover, the marketing campaign will involve a cash cost of $4,000,000 per year.
As per the above forecasts and assume they remain the same every year, this 10-year campaign will be able to generate free cash flows of $2,585,600 per year (ignored the change in working capital). Company A currently has 80% equity and 20% debt in the balance sheet. Regarding the equity, Company A shares have a beta coefficient of 1.4, while the risk-free rate is 2.5% and the expected return on market portfolio is 8.5%. On the liability side, Company A is paying an average before-tax interest rate of 8% per annum on its borrowings (the tax-rate in the U.S. is 30%).
Finally, to finance the strategy suggested by its marketing department, Company A must liquidate some investments due to tightened borrowing requirements. The company own two types of investments which can be sold: (i) Treasury bonds with $1,000 face value, 10 years to maturity, annual coupons of $50 and yield to maturity of 4% per year, and (ii) ordinary shares of another company, XYZ, which just paid a dividend of $0.50 per share, with dividend growth prospects of 5% per year and required rate of return of 10%.
I apprecicate the time to assist so I can understand how this method/framework works in the siutation. I have really struggled identifying the key aspects and analyzing this study. Thank-you again.