How investments are determined good or bad?

Solution

The solution is given below −

Total sales (in billion tons) – current = 16
Total sales (in billion tons) – proposed = 16 + 7 => 23

Incremental cash flows

• Sales

Current

Domestic sales => 8 * 80 => 640
Export sales => 8 * 120 => 960
Total current sales = 640 + 960 => 1600

Proposed

Domestic sales => 12 * 80 => 960
Export sales => 11 * 120 => 1320
Total current sales = 640 + 960 => 2280

Incremental = proposed – sales => 2280 – 1600 => 680

• Variable cost => (11*20) + (12*15) => 220 – 180 => 40
• Contribution margin => sales – variable costs
  • Current => 1600 – 180 => 1420
  • Proposed => 2280 – 220 => 2060
• Fixed cost
  • Current => 140
  • Proposed => 260

Net cash => contribution margin – fixed cost

• Current => 1420 – 140 => 1280
• Proposed => 2060 – 260 => 1800

Incremental => net cash (proposed) – net cash (current) => 1800 – 1280 => $520 billion

Pay back => initial investment/ net cash (incremental) => 1000/ 520 => 1.92 years (approximately)

Calculated payback (1.92 years) is less than estimated payback (4 years)

Hence, we can conclude that it is a good investment.