Question 1: Clyach Plc: A Capital Expenditure Decision

a) Determine the net present value of the investment. Set out your
calculations clearly and specify the critical assumptions.

Net Present value = Present value of Inflow – Present value of Outflow

= £473,511.24
[ CITATION Net \l 1033 ]

Working Notes:

1. The cost that has already been incurred is not considered while making capital
budgeting decisions. The cost is referred to as sunk cost. Therefore, £400,000 is not
considered during evaluation.
2. Depreciation has been spread over the span of ten years. For calculation of actual
tax to be paid to the government, the policies of the same must be followed
irrespective of the anticipated commercial life of the product.
3. Depreciation Tax shield is spread over a period of 10 years.
Depreciation tax shield = Depreciation x Tax rate
4. The residual (re-sale) value of the production line is expected to be £250,000 in the
5th year.
5. Allocated cost is not considered while making capital budgeting decision
Allocated costs include:
Space occupied expenses = 40,000
Overhead cost = 8% of labor expense

Year 1 2 3 4 5
Overhea 86,400 97,200 97,200 97,200 97,200
d (1080000*.0 (1215000*.0 (1215000*.0 (1215000*.0 (1215000*.0
expense 8) 8) 8) 8) 8)

6. Selling price = 35
Variable cost = 27, Material cost =13.5 (50%)
Labor Cost = 13.5 (50%)
7. Fixed cost is incurred specifically for the product and is therefore included while
making capital budgeting decision.
8. Promotion and marketing expenditure is included in the initial cost.

9. Initial costs include:

Initial outlay: £1,500,000

Promotion and marketing: £70,000
10. The required rate of return is 14%
11. Tax rate is 30%.
12. Cost of goods sold calculations:
b. Explain what is meant by sensitivity analysis, determine and discuss the
sensitivity of the investment’s NPV to deviations in the expected price from the
assumed value of £35 per unit.

Sensitivity analysis helps in determining the sensitivity of the project with respect to an input
keeping other variables constant. It helps in estimating what will happen to the project if the
assumptions and estimates turn out to be unreliable. In capital budgeting calculations,
sensitivity analysis changes one estimate at a time to see how the result changes.
Because of Sensitivity analysis, business managers better analyze the project before making the
investment as it prepares them for the worst situation.

Sensitivity of the investment’s NPV to deviations in the expected price from the assumed
value of £35 per unit:
If selling price decreases by 5%
Current selling price = 35
Expected selling price = 35 - 5% = 31.5
 Expected NPV = Present value of inflow – Present value of Outflow
= £105,759.68

Percentage decrease in NPV = Current NPV – Expected NPV x 100

Current NPV
= £473,511.24 - £105,759.68 x 100
£473,511.24
Percentage decrease in NPV = 77.66%

If the Selling price of the project decreases by 5%, then the NPV will decrease by
77.66%. The sensitivity analysis of the NPV with respect to Selling price is 77.66%. It
shows that the NPV of the project is highly affected by the change in Selling price. So
the business managers should more critically investigate to the Selling price of the
product before making the investment decision. [ CITATION Sen \l 1033 ]

c. Explain the principles underlying the treatment of net working capital in

investment appraisal and comment on the approach you adopted in the
evaluation of Clyach’s proposed investment.
Working capital refers to the difference between current asset and non-current asset. Change
in working capital leads to either increase or decrease in cash flow. With the decrease in
accounts receivable cash flow increases and vice versa. Also with the decrease in accounts
payable cash flow decreases and with its increase cash flow increases. Therefore, with the
change in working capital from period to period there is a change in cash flow which in turn, has
an event on net present value used for investment appraisal. [ CITATION Doy \l 1033 ]
Net Present value method (NPV Method) has been used in the evaluation of Clyach’s proposed
investment. This method helps in determining the Net inflow the project will generate for the
company taking into consideration time value of money. It is based on the idea that an amount
received in the future are of less worth as compared to the amount we will receive today.
Positive NPV indicates that the project can be accepted. The NPV directly increases the
shareholder’s wealth which further helps in increasing the market value of the company.
[ CITATION Net \l 1033 ]