Question

Question # 01                                                                                                                  [10 marks]
ABC Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Jameel, a recently graduated MBA. The production line would be set up in unused space in the main plant. The machinery’s invoice price would be approximately Rs 5,000,000, another Rs 250,000 in shipping charges would be required, and it would cost an additional Rs 750,000 to install the equipment. The machinery has an economic life of 4 years, and ABC Company applicable depreciation rate are 33.33% for year 1, 44.45% for year 2, 14.81% for year 3, 7.41% for year 4. The machinery is expected to have a salvage value of Rs 625,000 after 4 years of use. The new line would generate incremental sales of 1,250 units per year for 4 years at an incremental cost of Rs 2500 per unit in the first year, excluding depreciation. Each unit can be sold for Rs 5,000 in the first year. The sales price and cost are both expected to increase by 3% per year due to inflation. Further, to handle the new line, the firm’s net working capital would have to increase by an amount equal to 12% of sales revenues. The firm’s tax rate is 40%, and its overall weighted average cost of capital, which is the risk-adjusted cost of capital for an average project (r), is 10%.     
      

Required:
i. What are the annual depreciation expenses?
ii. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to include inflation when estimating cash flows?
iii. Construct annual incremental operating cash flow statements.
iv. Estimate the required net working capital for each year and the cash flow due to investments in net working capital.
v. Calculate the after-tax salvage cash flow.
vi. Calculate the net cash flows for each year. Based on these cash flows and the average project cost of capital, what are the project’s NPV

Answer 1

Based on the given data, pls find below steps, workings and answers highlighted in yellow:

The NPV of the Project is negative $ 29786.46 and is not feasible.

Computation of Net Present Value (NPV) based on the Discounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) ; Year 2 = Year 1 factor/(1+discounting factor %) and so on;

Next, the cashflows need to be multiplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;