Blossom Co: Capital Investment Appraisal

Introduction to Managerial Accounting

Anna Hovhannisyan, Meri Danielyan, Arpi Orujyan,
Edvard Khachatryan, Gor Karapetyan
Introduction

The main objective of our group’s report is to evaluate the proposed capital project
and investment in working capital Blossom Co is planning to implement for the purpose of
increasing the capacity of the business. The goal for our group was to determine whether the
project is worth undertaking through various investment appraisal techniques. To understand
whether the suggested capital project is financially acceptable or not, we have calculated the
forecasted benefits as well as actual expenditure that the business will incur in case of
accepting the project.
The essence of the project is that Blossom Co is planning to purchase new machinery
with useful life of 5 years aiming to increase the capacity of the business which,
consequently, will result in increase in annual sales. We will estimate the viability of the
project using different discount rates to calculate NPV and Payback Period of the project.

Capital Investment Appraisal

1) Net Present Value
We will start our analysis with identifying the Net Present Value of the project. The
discount rate that we are going to use for estimating the impact of the project on the profit of
the company is 17%. For the purpose of calculating cash flows of the business throughout the
useful life of the asset, we had to take into consideration the annual increases in selling price,
sales volume and costs.
Selling price: As a result of the purchase of new machinery, the selling price of the
company is projected to increase once by 5% starting from the third years of its operation.
Sales volume: It is predicted that the investment will increase the capacity of the
business, consequently, annual sales will increase by 5,000 units.
Production costs: In relation with increase in capacity of the business and with
expenses of running the machinery, production costs are forecasted to increase by 8% as well,
starting from the third year. This will impact both variable and fixed production overheads
resulting in incremental fixed cost of $17,600 ($220,000*8%) and increase in variable cost
per unit (from $150 to $162).
 Non-production costs: With regard to increase in capacity, administration and
distribution expenses are also going to increase impacting variable non-production overheads
and increasing variable non-production costs per unit to $50.

Year 0: The capital investment will cost the company $3.2 million resulting in cash
outflow of $3,200,000.
Year 1: Cash flow calculations show that already in the first year the company will
have inflow of cash amounting $1.25. This is resulting from increased sales (+5000) which
directly impacts the annual revenue and profit of the company. Additionally, the company
will have investment in working capital which will cost $0.5 million. Deducting cash inflow
from outflow and multiplying the amount with the discount factor (0.86) we can calculate the
Present Value of the return on investment in the first year, which will be equal to $641,250.
Year 2: During the second year the net cash flow is increasing being equal to
$1,250,000. In contrast to the first year, the cash inflow is not reduced by investment in
working capital during this year and given that sales volume, price and costs have remained
unchanged throughout the year the net cash flow has gone up. Another change is in discount
factor which became 0.73, therefore decreasing the Present Value of annual net cash inflow
($913,750).
Year 3: Throughout the third year, both the selling price and production expenses
increase. Production costs rise as a result of the increase in capacity and the company may
have decided to raise prices as it needs to recover the expenses incurred. In spite of the fact
that increase in production costs (∆C=8%) was more than increase in selling price (∆P=5%),
revenue has risen more than costs, resulting in increased net cash inflow ($1,284,900).
Multiplying this number with DF (0.624) we get $801,777 which is the Present Value of the
cash inflow of third year.
Year 4: The picture does not change much during the fourth year. The Cash Flow is
the same as in the previous year; the only change is again in DF, the decreasing tendency of
which decreases the Present Value of net cash inflow making it equal to $686,136.
Year 5: During the last useful year of the machinery the investment in working
capital is recovered resulting in additional cash inflow of $500,000 which is added to net
inflow of the year comprising in total $1,784,900. This makes the Present Value of the inflow
equal to $813,914. Since we are not provided with any information about residual value of
the equipment, we assume it to be equal to $0.
Summing up all the net cash flows throughout 5 years and deducting the initial cost of
purchasing the asset as well as incremental costs incurred in working capital, the company is
forecasted to have a profit of $656,828 from the project. The fact that the company is going
to have such a surplus in funds undoubtedly means that the project is viable and financially
worth undertaking.

2) Discounted Payback Period

The next step in our analysis is to determine the time proposed project will take to pay
back the money spent on it in case of being accepted. According to our calculations the
company will recover its expenses on the machinery 4 years and 5 months after the purchase.
As it can be seen from the chart, during the fifth year, the cumulative cash flow sign changes
from negative to positive. This means that, at some point between year 4 and 5 (more
precisely, 2 months after the fourth year), the cost of financing (the summation of the initial
cost of the machinery of $3.2 million and the investment in working capital of $500,000)
would be recovered by generated profit. It should be noted that the costs will be paid back
only shortly (10 months) before the end of useful life of the asset. Such a long Payback
Period indicates that there is a greater risk that the company will not get the invested capital
recovered. Nevertheless, since the Payback Period is shorter than the maximum return time
allowed (5 years), the project is financially acceptable being evaluated with this technique as
well.

3) The feasibility of the Project at a Discount Rate of 25%

The feasibility of the project is also calculated at the discount rate of 25%. For
calculations, we used the cash flows of the company with the changed discount rates to find
the Present Values.

Year 1: In the first year the discount factor changes from 0.85 to 0.8 as the discount
rate changes from 17% to 25%. Therefore, the Present Value at the discount rate of 25%
($600,000) is lower.
 Year 2: With the change of discount factor (0.64) the Present Value of the cash flow
of the second year equals to $800,000.
Year 3: The Present Value of the cash flow in the third which has the discount factor
of 0.512 will equal to $657,869.
Year 4: With a discount factor of 0.41, the cash flow will have a Present Value of
$526,295.
Year 5: In its last year of operation, the machinery will attract cash inflows with a
Present Value of $584,876 (discount factor 0.33).

The Present Values of all the years, except the Year 0, are positive with both 17% and
25% discount rates. The reasons for these results are the positive cash flows which lead to
positive Present Values.
The high percentage of the discount rate (25%) lowers the Present Values of the cash
flows making it not only impossible to recover the costs during the operating time of the
machinery but also have a loss of $30,960. Machinery needs replacement after five years, and
the NPV of -$30,960 shows that the investment is not profitable at the discount rate of 25%;
therefore, the project should be rejected unless available with lower cost of capital.

Conclusion
To sum up, incorporating key capital appraisal techniques in our report and
calculating necessary financial information, we conclude that the project is viable and should
be accepted. Being superior to other investment appraisal methods, the results of the Net
Present Value analysis show that, at suggested cost of capital (17%), the new machinery is
not only capable of recovering the cost of investment but also will raise additional surplus
increasing shareholders’ wealth and leading to overall growth of the company. Moreover,
Payback Period analysis shows that, at a rate of 17%, the machine can pay the money back
spent on its acquisition 10 months before the end of its useful life meaning that the project
meets the criteria of quick payback as well.
 Selling price (per $
unit) 450.00

Variable production $
cost (per unit) 150.00

Incremental non- $
production cost 250,000.00
Fixed production $
cost 220,000.00
Working capital $
investment 500,000.00

Annual Increases
Sales Incremental fixed
Variable production
volume Selling price (per unit) production costs
costs (per unit)
(units) (per unit)
Year 1 5,000 $ 450.00 $ 150.00 $ -
$
Year 2 5,000 $ 450.00
150.00 $ -
$ $
Year 3 5,000 $ 472.50
162.00 3.52
$ $
Year 4 5,000 $ 472.50
162.00 3.52
$ $
Year 5 5,000 $ 472.50
162.00 3.52

Incremental Fixed
Sales Revenue Variable Costs Annual Inflows
Cost
Year 1 $ 2,250,000.00 $ 1,000,000.00 $ - $ 1,250,000.00
Year 2 $ 2,250,000.00 $ 1,000,000.00 $ - $ 1,250,000.00
$
Year 3 $ 2,362,500.00 $ 1,060,000.00 $ 1,284,900.00
17,600.00
$
Year 4 $ 2,362,500.00 $ 1,060,000.00 $ 1,284,900.00
17,600.00
$
Year 5 $ 2,362,500.00 $ 1,060,000.00 $ 1,284,900.00
17,600.00
 Cash flow Discount Factor Present Value

Year 0 $ (3,200,000.00) 1 $ (3,200,000.00)

Year 1 $ 750,000.00 0.855 $ 641,250.00
Year 2 $ 1,250,000.00 0.731 $ 913,750.00
Year 3 $ 1,284,900.00 0.624 $ 801,777.60
Year 4 $ 1,284,900.00 0.534 $ 686,136.60
Year 5 $ 1,784,900.00 0.456 $ 813,914.40
Discount Rate 17% NPV $ 656,828.60

Payback Period (disc. rate-17%)

Present Value Cumulative Cash Flow
$
Year 0
$ (3,200,000.00) (3,200,000.00)
$
Year 1
$ 641,250.00 (2,558,750.00)
$
Year 2 $ 913,750.00
(1,645,000.00)
$
Year 3 $ 801,777.60
(843,222.40)
$
Year 4 $ 686,136.60
(157,085.80)
Year 5 $ 813,914.40 $ 656,828.60

Months taken to pay back in Year 5 2.32

Total Payback Period 4 year 2 months

Cash flow Discount Factor Present Value

Year 0 $ (3,200,000.00) 1 $ (3,200,000.00)

Year 1 $ 750,000.00 0.80 $ 600,000.00
Year 2 $ 1,250,000.00 0.64 $ 800,000.00
Year 3 $ 1,284,900.00 0.512 $ 657,868.80
 Year 4 $ 1,284,900.00 0.41 $ 526,295.04
Year 5 $ 1,784,900.00 0.328 $ 584,876.03
Discount Rate 25% NPV -$30,960

Payback Period (disc. rate-25%)

Present Value Cumulative Cash Flow
$
Year 0
$ (3,200,000.00) (3,200,000.00)
$
Year 1
$ 600,000.00 (2,600,000.00)
$
Year 2
$ 800,000.00 (1,800,000.00)
$
Year 3
$ 657,868.80 (1,142,131.20)
$
Year 4
$ 526,295.04 (615,836.16)
$
Year 5
$ 584,876.03 (30,960.13)