Financial Analysis: NPV, IRR, and AEC for Business Projects

This finance assignment provides a detailed analysis of three business projects, focusing on Net Present Value (NPV), Internal Rate of Return (IRR), and Annual Equivalent Cost (AEC). The assignment begins by calculating the NPV of a project, considering depreciation, working capital changes, and capital gains tax on salvage value. It then assesses a replacement project, highlighting incremental cash flows from labor savings, inspection cost reductions, and depreciation differences. The NPV and IRR of the replacement project are calculated to determine its feasibility. Finally, the assignment analyzes two sound systems, computing their AECs and NPVs, including tax savings and salvage values, to identify the preferred system based on cost-effectiveness. The assignment demonstrates the application of financial concepts to evaluate investment opportunities and make informed business decisions.

BUSINESS FINANCE
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Question 1
(a) The project NPV is estimated based on the table shown below.
Explanations:
1) Depreciation = (Fixed investment/Useful life) = (240000/3) = $ 80,000
2) Increase in working capital = Increase in current assets – Increase in current liabilities =
(22000 + 14000 – 18500) = $ 17,500
3) NPV is the sum of the present value of all cash flows during the project.
4) It is assumed that all cash flows are occurring at the end of the year.
5) Capital gains tax has been applied on salvage value @ 30%.
(b) It is apparent that the project NPV is positive and hence the project would be accepted. A
project with positive NPV would increase the wealth of the shareholders and create value for
them.
Question 2
a) The key effect of the replacement project is highlighted below.

1) For the automated machine, no labour would be required and hence the entire labour cost
in the existing machine would be saved which would amount to $ 320,000 p.a.
2) Also, there would be an annual savings in the inspection cost as currently it is $ 20,000 p.a.
and with the automated machine, it would go down to $ 4000 p.a.
3) The maintenance cost is higher for the automated machine and the difference in the
maintenance cost is $ 28,000 p.a.
4) Depreciation of existing machine = (200000/12) = $ 16,666.67 p.a.
Depreciation on new automated machine = (600000/8) = $ 75,000 p.a.
Hence, higher depreciation = $ 75,000 - $ 16,666.67 = $ 58,333.33
5) Book value of existing machine = 200000 -4*16,666.67 = $ 133,333
Disposal value of existing machine = $ 50,000
Loss on disposal = 133333- 50000 = $ 83,333
Savings of tax owing to the above loss = 0.3*83333 = $ 25,000
The relevant incremental cash flows from the replacement project is indicated below.
(b) The NPV of the project has come out as $ 718,571. Since the NPV of the project is
positive, it would be considered as a feasible project and should be implemented. With
regards to IRR, the corresponding project IRR is 41.66%. Clearly, this is greater than the cost
of capital of the project which implies that the project would be feasible. If the IRR would
have been lower than the cost of capital, then the project is considered as not feasible. IRR is
defined as the discount rate for which NPV is zero.

Question 3
a) The AEC for the two sound systems has been indicated below.
AEC = Upfront costs/Discount factor + Annual operating costs
The preferred system would be Audio-Aura since it has a lower AEC .
b) For this, the NPV of the two systems has been sound since the salvage value and tax also
need to be considered in this case.
Tax savings on depreciation = Depreciation *0.3
After tax salvage value = Before tax slave value *(1-0.3)
The relevant formula used for computation of AEC from NPV is indicated as follows.

The summary of the NPV and the relevant AEC of the two projects is shown below.
Based on the above output, it is apparent that the preferred system would be Audio-Aura
since the AEC is lower.