Question

Question 3 – Capital Investment Analysis

The management team of Accent Group Limited have received a proposal from the manager of Hype DC. This proposal concerns a major upgrade to Hype DC's stores to improve the customer experience. Key details relating to this proposal include:

• The initial cost will be $22 million. This cost will be depreciated using the straight line method over the 5 year life of the upgrade.
• During year 1, the firm will increase marketing costs by $2.0 million to promote the store upgrades.
• Over the five year life of the project, it is expected that the upgrade will increase the firm's sales by $18 million per year. On average, cost of sales is 45% of revenue.
• The firm will need to higher additional staff over the life of the project to help to deal with the increased sale volume. In year 1, the firm's staffing costs will increase by $1.0 million. These costs will increase by 3.5% p.a.
• The upgrade is expected to increase the firm's energy costs by $500,000 in year 1. This increase will be ongoing across the life of the project and will increase by 6% p.a.
• Upgraded stores will include an old shoe recycling drop off zone. This recylcing program will cost $75,000 in year 1. These costs will increase by 2% p.a.
• At the end of year 3, the firm will spend $1.5 million on a minor refurbishment to the stores.

The firm’s tax rate is 30%. The firm requires a 16% required rate of return on all potential investments.

Required

In relation to the above proposal:

1. Calculate the annual after tax cash flows and annual after tax profit .
2. Calculate the payback period .
3. Calculate the net present value .
4. Calculate the internal rate of return.
5. Calculate the accounting rate of return .

Answer 1

Answer 1

Calculation of annual after tax cash flow and annual after tax profit-

Year	Increase in sales	Depreciation	Increase in marketing cost	Cost of sales	Increase in staff cost	Increase in energy cost	Recycling program cost	Refurbishment cost	Profit before tax	Tax @30%	Profit after tax	Add back depreciation	Cash flow after tax	PV factor @16%	PV of cash flow after tax
1	18000000	4400000	2000000	8100000	1000000	500000	75000		1925000	577500	1347500	4400000	5747500	0.862068966	4954741.38
2	18000000	4400000		8100000	1035000	530000	76500		3858500	1157550	2700950	4400000	7100950	0.743162901	5277162.60
3	18000000	4400000		8100000	1071225	561800	78030	1500000	3788945	1136683.5	2652261.5	4400000	7052261.5	0.640657674	4518085.45
4	18000000	4400000		8100000	1108717.88	595508	79590.6		3716183.53	1114855.06	2601328.47	4400000	7001328.47	0.552291098	3866771.39
5	18000000	4400000		8100000	1147523	631238.48	81182.41		3640056.11	1092016.83	2548039.28	4400000	6948039.28	0.476113015	3308051.93
Total											11850079.24		33850079.24		21924812.75

Answer 2

Calculation of Payback period-

Year	Cash flow after tax	Cumulative cash flow
1	5747500	5747500.00
2	7100950	12848450.00
3	7052261.5	19900711.50
4	7001328.47	26902039.97
5	6948039.28	33850079.24

Payback period = Year before full recovery + (unrecovered cost at start of year / cash flow during the next year)

= 3 + (2099288 / 7001328.47)

= 3 + 0.30 = 3.30 years

Answer 3

Calculation of Net present value-

NPV = Present value of Net cash flow after tax - Initial investment

= 21924812.75 - 22000000

= $75187.25

Answer 4

Calculation of Internal rate of return-

Year	0	1	2	3	4	5
Cash flow	-22000000	5747500	7100950	7052262	7001328	6948039

In excel by using IRR formula we will get 15.86% which is more or less equal to current rate of return.

Answer 5

Calculation of accounting rate of return-

ARR = Average Profit after tax / Initial Investment

= (11850079.24 / 5) / 22000000

= 2370015.85 / 22000000

= 10.77%