Armstrong Ltd manufactures watertight metal cases for electronic equipment used on ships. Armstrong has divisions operating throughout Australia. Division managers receive a bonus each year based on their accrual accounting rate of return for that year (with calculations based on end-of-year total assets). At the moment, the Sydney Division generates cash revenues of $1 500 000, incurs cash costs of $900 000 and annual depreciation of $200 000, with an investment in assets of $9 900 000. New technology has recently been developed to build custom cases that eliminate wasted space. This new technology would allow the Sydney Division to expand into making cases for the aviation industry. The manager estimates that the new technology will require an investment in working capital of $65 000. Because the company already has a facility, there would be no additional rent or purchase costs for a building, but the project would generate an additional $190 000 in annual cash overhead. Moreover, the manager expects annual materials cash costs for the expansion to be $700 000 and labour to be about $450 000. The management accountant of Armstrong estimates that the expansion would require the purchase of equipment with a $2 300 000 cost and an expected disposal value of $400 000 at the end of its seven-year useful life. Depreciation would occur on a straight-line basis. The management accountant of Armstrong determines the company’s cost of capital as 6%. The management accountant’s salary is $160 000 per year; the expansion will not change that. The CEO asks for a report on expected revenues for the project, and is told by the Marketing Department that it might be able to achieve cash revenues of $1 750 000 annually from the aviation industry. Armstrong has a tax rate of 30%. Required 1. Describe the five stages of the capital budgeting process for this expansion project. 2. Separate the cash flows into four groups: (a) net initial investment cash flows; (b) cash flows from operations; (c) cash flows from terminal disposal of investment; and (d) cash flows not relevant to the capital budgeting problem. 3. Calculate the NPV and IRR of the expansion project and comment on your analysis. 4. What is the payback period on this expansion? 5. Calculate the overall AARR (based on average investment) of the new technology. 6. Comment on the impact that the investment will have on the manager’s bonus over the course of the seven years. 7. Without doing any calculations, comment on the effect on the payback period and the NPV of: a. a decrease in the estimated salvage value from $400 000 to $100 000 b. a change in the tax rate from 30% to 40%.
Armstrong Ltd manufactures watertight metal cases for electronic equipment used on ships. Armstrong has divisions operating throughout Australia. Division managers receive a bonus each year based on their accrual accounting
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