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12-04-2018

Managerial Finance:

Answer the two questions below. 

Question 1

Solus, an Australian manufacturer of Scientific Equipment, is considering expanding its Australian operation.  It is considering an investment in new plant of $4.8 million.  The project will be financed with a loan of $2,400,000 which will be repaid over the next five years in equal annual end of year instalments at a rate of 8.60% percent pa.  Assume diminishing value depreciation over a five-year life, and no taxes. The project’s cash flows before loan repayments and interest are shown in the table below. Cost of capital is 13.80% pa (the required rate of return on the project). A salvage value of $325,000 is expected at the end of year five and is included in the cash flows for year five below. Ignore taxes and inflation.

Year

Year One

Year Two

Year Three

Year Four

Year Five

Cash Inflow

2,080,000

1,200,000

1,930,000

1,105,000

1,245,000

REQUIRED:

  1. NPV of the project (to the nearest dollar)
  2. IRR of the project (as a percentage to two decimal places)
  3. PB, the payback in years (to one decimal place)
  4. ARR, the accounting rate of return (to two decimal places)
  5. PI (present value index or profitability index) (to two decimal places)
  6. Is the project acceptable? You must provide a decision or explanation for each of the methods in parts (1) to (5). Why or why not (provide a full explanation)? Also a brief explanation of your treatment of Salvage Value and Loan Repayments is required. (600 words).

Question 2

Multimakks Limited Steel Division is considering a proposal to purchase a new machine to manufacture a new product for a potential three-year contract.  The new machine will cost $12.8 million.  The machine has an estimated life of four years for accounting and taxation purposes. The contract will not continue beyond four years.   An investment allowance of twenty percent on the outlay is available.  Extra marketing and administration cash outflows of $251,000 per year will be incurred by the Steel Division for the project.  The projections provided here are based on the feasibility study undertaken by HXBC bank.  Cash operating expenses are estimated to be 68 percent of sales revenue (excludes marketing and administration, and head office items). Except for initial outlays, assume cash flows occur at the end of each year (unless otherwise stated).

Additional Information

  1. The sales price per unit of product is $158.     
  2. Estimated Sales volume of the product is 152,000units for Year 1.  In years 2, 3 and 4 the total sales revenue will increase in line with economic growth. 
  3. The nominal economic growth rate is projected to be 4% per year.
  4. The project will be in operation for 4 years; then it will terminate.  In the final year of the project the machinery will be sold for 7.5% of its initial, total value. 
  5. Last year, Multimakks Ltd. paid HZPC Bank $500, 000 for a feasibility study that confirmed the manufacturing expansion was economically viable. 
  6. The machinery is considered depreciable for tax purposes and will be depreciated using a diminishing value method (This is equal to twice the annual straight-line rate).
  7. The project will require a provision of $370,000 in working capital. 
  8. There will be additional Sales and Marketing expenses if the project goes ahead. This has been estimated to be $251,000 for Year 1.  After this, the additional annual Sales and Marketing expenses will increase with inflation. 
  9. Head Office expenses will not increase.  However, a fixed allocation of $230,000 per year will be charged to this project. 
  10. Cash operating expenseswill be 68% of Sales Revenue. 
  11. The investmentproject is considered not to be in line with the company’s core business and is of a higher risk.
    • HZBC calculated the real required rate of return on a higher risk project such as this to be 10.65% (after tax). 
  12. Inflation is projected to be 2.0% per year for the period of the investment.
  13. The company tax rate is 27% and tax is paid in the year after the income is earned.
  14. Assume all cash flows are in Nominal values, unless otherwise stated. 

REQUIRED:

  1. Calculate the NPV.  Is the project acceptable? Why or why not?
  2. Conduct a sensitivity analysis showing how sensitive the project is to sales revenueand to the cost of capital. Explain.
  3. From a theoretical perspective, what additional insight can Scenario analysis give, that sensitivity analysis cannot? (You may use numbers to illustrate your answer but you do not have to). 
  4. Explain how risk has been priced into this project and explain the extent to which management may be confident the return on investment is in accordance to its risk. 
Download Questions

NPV stands for “NET PRESENT VALUE”, it is the difference between present value of cash inflows and the present values of cash outflow. It is used to analyze the profitability of a projected investment or project. A positive net present value indicates that the projected earnings generated by a project or investment exceeds the anticipated costs. Generally, an investment with positive NPV will be a profitable one and one with a negative NPV will result in a net loss. NPV rules indicate that the only investment that should be made are those with positive NPV values. Sensitivity Analysis Sensitivity analysis tells about the riskof error of estimation in certain variables to which the return is dependent. It helps to analyse the level of fluctuation which can be tolerated and after which the project would provide negative NPV thereby destroying shareholder’s wealth. It generally helps in effective decision making . Hence sensitivity analysis of sales and cost of working capital has been carried out inorder to judge the risk associated with the project and its viability.

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