What is the rate of return on investment ? The research department of a large sp
ID: 1195409 • Letter: W
Question
What is the rate of return on investment ?
The research department of a large specialty monomer and polymer company has developed and formulated a new product. Early test have been encouraging regarding the use of this product as a high performance adhesive and sealant for cracks and joints in new and old cured concrete. A preliminary design study has just been completed. The estimated economic analysis relevant to the project include the following items. Production when at 100% of capacity = 2 + 10^6 kg/yr A batch process It has been determined that the product can sell at a price of $11.50/kg. Total capital investment = $ 28,000,000 Fixed-capital investment = $ 24,000,000 Sum of the variable product costs at full capacity = $ 5 million/yr Sum of the fixed costs (except depreciation) = $ 1 million/yr Other data Use MACRS depreciation (with a half-year convention) assuming a 5 year recovery period. There is no salvage or scrap value. The tax rate is 35% per year. Due to the nature of the project, working capital can be neglected. All of the capital investment occurs at time zero. This is considered a higher risk project. Therefore, the minimum acceptable rate of return (or threshold rate of return) is 30%/yr.Explanation / Answer
Total Capital Investment = $28,000,000
Calculation of Total Income for the first year:
Production at 100% capacity = 2* 10^6 kg/ year.
Since for the first year, the company works at 50% capacity, the total production is 1,000,000 units
Total Income for first year = 1,000,000 * 11.50 = $11,500,000
Total income for subsequent years = 1,800,000 * 11.50 = $20,700,000 = $82,800,000
Income for five years = $94,300,000
Calculation of Total Cost:
Sum of Variable products cost at full capacity = $5,000,000
Sum of Variable products costs at 50% capacity = $2,500,000
Sum of fixed cost = $1,000,000 + Depriciation
Calculation of depreciation of fixed investment using MACRS depreciation method:
Since it is not mentioned as real property, we can choose between 200% declining balance method or straight line method. SInce we have to recover cost as fast as possible, we choose 200% declining balance method.
Depreciation for the first year = Cost * 1/Useful life * Depriaciation method * convention rate
= 24,000,000 * 1/5 * 200/100 * 0.5 = 4,800,000
Depreciation for second year = (24,000,000 - 4,800,000) * 1/5 * 200/100
= 7,680,000
Depreciation for third year = (24,000,000 - 7,680,000) * 1/5 * 200/100
= 6,528,000
Depreciation for fourth year = (24,000,000 - 6,528,000) * 1/5 * 200/100
= 6,988,800
Depreciation for fifth year = (24,000,000 - 6,988,800) * 1/5 * 200/100
= 6,804,480
Hence, sum of fixed cost = $4,800,000 + $1,000,000 = $5,800,000
Tax per year = 30/100 * 11,500,000 = $3, 450,000
Return Amount = 11,500,000 - (5,000,000 + 5,800,000 + 3,450,000) = -2,750,000
SInce, the return amount is lesser than minimum acceptable rate of return , the project cannot be considered,
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