CAPITAL BUDGETING (Case Study)
The Case:
Currently Etihad International School provides its students with snacks and lunch meals by contracting withoutsources, at relatively high prices.
Recently the school started to consider the idea of establishing its own kitchen with the needed cooking equipment to prepare in-house food with a higher quality and lower cost.
The initial cost of the kitchen equipment is estimated to be AED 600,000. The kitchen is expected to operate for 7 years, after which the kitchen equipment would have to be scrapped with a salvage value of AED 40,000.
The management has come up with the following projected Revenues and Cost data for the next 7years.
|
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Year 6 |
Year 7 |
| Revenues |
300,000 |
350,000 |
410,000 |
480,000 |
520,000 |
480,000 |
450,000 |
| Salaries |
60,000 |
65,000 |
77,000 |
90,000 |
90,000 |
90,000 |
70,000 |
| Maintenance & repairs |
10,000 |
12,000 |
20,000 |
25,000 |
28,000 |
30,000 |
35,000 |
| Other Costs |
110,000 |
128,000 |
150,000 |
180,000 |
185,000 |
185,000 |
190,000 |
To raise funds for this project the school is proposing to raise a long-term loan at 10% interest rate per annum.
You are told that there is an alternative project that could be invested in using the funds which has the following projected results:
- Payback period = 3 years
- Accounting rate of return (ARR) = 20%
- Net present value = AED 100,000
As funds are limited, investment can only be made in one project only.
Note: The kitchen equipment would be purchased at the beginning of the project and all other expenditure would be incurred at the end of each relevant year.
Required:
1. Calculate the projected net income and cash flows over the life of the Heathy Food project and fill them in a table.
Hint: You need first to calculate the annual depreciation expense on the kitchen equipment.
2. Calculate the following for the Healthy Food project:
(i) Payback period
(ii) Accounting rate of return
(iii) Net present value
3. Write a short memo to the financial manager in your school explaining whether the school should invest in the Healthy Food project or choose the alternative project available. You must clearly explain the reasons for your decision.
4. Explain the disadvantages of using the accounting rate of return method in making a capital budgeting decision.