Question

The manufacturing firm Rebo is considering a new capital investment project. The project will last for five years. The anticipated sales revenue from the project is $3 million in year 1 and $4.2 million in each of years 2 – 5. The cost of materials and labour is 50% of sales revenue and other expenses are $1 million in each year. The project will require working capital investment equal to 20% of the expected sales revenue for each year. This investment must be in place at the start of each year. Working capital will be recovered at the end of the project’s life.

The project will require $2.5 million to be spent now on new machinery which will have zero value at the end of the project and will be depreciated each year at 20% of the original cost. The tax rate is 25%. Rebo uses a discount rate of 11% to evaluate its capital investment projects.

What is the net income in each year?

(ii) What is the free cash flow in each year and the net present value (NPV)?

(iii)You discover the following additional information:

• The project will utilise a building that the firm leases. No other activities take place in it. If this project does not go ahead the firm will terminate the lease in one year’s time if no other use for it has been found.

• Part of each year’s cash flows from the project will be used to increase the dividend payment to shareholders.

For each of these items, explain briefly whether or not you would incorporate the information into your analysis of the project’s value.

Answer 1

Workings:

Workings:

(iii) the following additional information:

• The project will utilise a building that the firm leases. No other activities take place in it. If this project does not go ahead the firm will terminate the lease in one year’s time if no other use for it has been found.

This is a relevant cash-flow as this is an opportunity cost if the project is not undertaken, the firm will not have this lease cost. Hence, the cash-flow related to this information should be included in the analysis of the project's value.

• Part of each year’s cash flows from the project will be used to increase the dividend payment to shareholders.

Dividend payment is only a distribution of the cash-flow generated and does not in any-way influence the project's future cash-flows. Hence, the cash-flow related to this information should not be included in the analysis of the project's value.