Question

Pandalela Products manufacturers a variety of household products. The company is considering introducing a new detergent. The company's CFO has collected the following information about the proposed product.

* The project has an anticipated economic life of 4 years.

*The company will have to purchase a new machine to produce detergent. The machine has an up-front cost (t=0) of RM 2million. The machine will be depreciated on a straight-line basis over 4 years (that is , the company's depreciation expense will be RM 500,000in each of the first four years (t = 1,2,3 and 4). The company anticipates that the machine will last for four years, and that after four years, its salvage value will equal zero.

* If the company goes ahead with the proposed product, it will have an effect on the company's net operating working capital. At the outset, t=0, inventory will increase by RM 140,000 and accounts payable will increase by RM 40,000. At t=4, the net operating working capital will be recovered after the project is completed.

* The detergent is expected to generate sales revenue of RM 1 million the first year ( t=1), RM2 million the second year (t=2), RM 2 million the third year (t = 3), and RM 1 million the final year (t = 4). Each year the operating cost (not including depreciation) are expected to equal 50% of sales revenue.

* The company's interest expenses each year will be RM100,000.

* The new detergent is expected to reduce the after tax cash flows of the company's existing products by RM250,000 a year (t=1,2,3 and 4).

* The company's overall WACC is 10%. However the proposed project is riskier than the average project for Pandalela Products; the project's WACC is estimated to be 12%.

* The company's tax rate is 40%.

a. Determine the relevant cash flows for this project.

b. What is the internal rate of return of the project?

c. What is the net present value of the project?

d. Should the company proceed with the project? Why?

Answer 1

internal rate of return of the project is -7.73% and net present value of the project is -$824,418.62. Company should not proceed with the project because both internal rate of return and net present value are negative. this project will generate losses.

the relevant cash flows for this project is Net cash flows for year 1-4 and year 0.

Working capital investment at year 0 is calculated as increase in inventory - increase in accounts payable. increase in inventory means cash outflow and increase in accounts payable means we have not paid the creditors which is cash inflow. So net cash outflow is $140,000 - $40,000 = $100,000. this net cash outflow will be recovered in year 4.

Reduction in cash flows is the reduction in after tax cash flows of the company's existing products. we need to reduce the after-tax cash flows of the new project by this amount because this project will kill the cash flows of existing products.

company's interest expenses are financial expenses and are not directly related to the project. In capital budgeting analysis, we consider only operating expenses which are directly related to operations of the project. so it will not be included in internal rate of return and net present value calculations.

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