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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.
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