Payback period for the investment of £250,000 needed to generate the earnings of £125,000
Thus, will be
250,000 ÷ 125,000
= 2 years
In another approach, Net Present Values of Profit Streams to be received in next 3 years and 5 years can be calculated to see if they are positive.
New investment needed is £250,000. If the same debt/equity ratio for financing the project i.e 50% each is considered then debt burden will be £125,000 and that will incur 8% interest charge.
The interest charge comes to £10,000.
Since the dividend declared is 16%, weighted average cost of capital employed can be taken as arithmetic mean of debt and equity for both being equal in magnitude.
Thus, the cost of capital to the company for this new project is 12% amounting to £30,000 per year. The cost of capital needs to be deducted from the yearly earnings to arrive at the net cash flow to the company and that amounts to 125,000-30,000= £95,000
However, the net profit of the operation after interest charge comes to 125,000-10,000=115,000
The depreciation of the plant and equipment is calculated on straight line method considering its useful life of 5 years.
That is calculated as £250,000/5= £50,000.
Thus, net profit to the company after charging interest, and depreciation is £65,000.
Development cost of £25,000 can be apportioned as per the laws towards its useful life; however, in absence of the details, we right now assume it to apportion in 5 years. Thus, development cost for each year comes to ?5,000 and can be deducted from the net profit of ?65,000. Thus, actual net profit is ?60,000. However, depreciation is not creating any cash outflow though dividend on the equity is an out flow for the company. So net cash generated to the company is ?90,000 only. (Adding depreciation of ?50,000 back to the net profit and deducting dividend of ?20,000 at the rate of 16% on equity of ?125,000) Assuming Demand Will Last for 3 Years The forecast is that the demand will last for only 3 years due to the advancement in technology, which means net cash flow of ?90,000 will be available to company for three years only. It will be appropriate to know the present worth of the cash flow generated based on the discounting factor of 12% (equivalent to the weighted average cost of capital), and the same can be given as 90,000/1.12+ 90,000 /1.122+ 90,000/1.123 =80,357+71,747+64,060 =?216,164 …………… …. (A) Assuming Demand Lasts For Full 5 Years of Equipment Life If the demand lasts for full 5 years to make a full utilization of equipment and machinery installed then the cash flow of ?90,000 will be generated for five years until the useful life of equipment and