Question

Sun Industries Ltd is involved in the production of materials for refinery services throughout the world. Currently the company is evaluating a project to produce ancillary products. The project duration is five years. The number of units produced is 40000 in the initial year. Thereafter the number of units produced increases by 15% every year. The inflation is estimated to be 2% per year. The initial investment for the project is estimated to be $5400,000. The annual fixed costs are estimated to be $550,000. The variable cost is $200 per unit. The selling price is $250 per unit. The initial fixed asset is depreciated straight line to zero over the five-year life period. The salvage value of the fixed asset equipment is $ 620,000. The initial investment in working capital is $350,000. Thereafter working capital will be 8 per cent of the annual sales revenues. The required discount rate is 10 per cent and the tax rate is 35 per cent. Estimate the project cash flows and state if you would approve the project by using appropriate capital appraisal techniques.

Answer 1

Data Given

Duration of the project	5 years
Number of Unis produced	40000 in intial year and there after increases by 15% every year
Inflation	2% Every Year
Initial investment (Fixed Assets)	$5400000
Annual fixed cost	$550000
Variable cost per unit	$200
Selling price per unit	$250
Salvage value at end	$620000
Initial working capitlal	$350000( There after working capital will be 8% of the sales revenue)
Discount rate	10%
Tax rate	35%

Particulars	Year 1	Year 2	year 3	year4	year 5
A.)Number of units produced (15% increase from 2nd year)	40000	46000	52900	60835	69960
(B)Selling price per unit (2% annual increase due to inflation)	$250	$255	$260.10	$265.30	$270.60
(C) Variable cost per unit (2%increase due to inflation)	$200	$204	$208.08	$212.24	$216.50
(D) Contribution per unit (B-C)	$50	$51	$52.02	$53.06	$54.10
(E) Total Contribution (D*A)	$2000000	$2346000	$2751858	$3227905	$3784836
(F) Less-Fixed cost (2% increase due to inflation)	($550000)	($561000)	($572220)	($583664)	($595338)
(G)  Operating profit or EBIT (E-F)	$1450000	$1785000	$2179638	$2644241	$3189498
(H) Less- Interest	0	0	0	0	0
(I) Depreciation ($5400000/5 year)	($1080000)	($1080000)	($1080000)	($1080000)	($1080000)
(J) Earning Before tax(G-H-I)	$370000	$705000	$1099638	$1564241	$2109498
(k) Less- Tax@35%	($129500)	($246750)	($384873)	($547484)	($738324)
(L) Earning after tax(J-K)	$240500	$458250	$714765	$1016757	$1371174
(M) Add - Depreciation	$1080000	$1080000	$1080000	$1080000	$1080000
(N) Less- Additional Woking capital needed (Check Woking note)	($450000)	($138400)	($162343)	($190419)	($223332)
(O)Add -residual velue of the fised assets	---	----	----	---	$620000
(P) Add- Recovery of working capital	---	----	----	----	$1514494
Cash Flow(L+M-N+O+P)	$870500	$1399850	$1632422	$1906338	$4362336
PVF@10%	0.909	0.826	0.751	0.6830	0.621
PV of the cash flow (Cash flow * PVF)	$791285	$1156276	$1225950	$1302030	$2709010

Note- Working capital at the end to be recovered

Total Present value of the future cash flow	$7184550
Less - Initial Investment ($5400000 in fixed assets and $ 350000 in working capital)	($5750000)
Net present value of the project	$1434550

Opinion-The project is profitable.

Working Note- Working capital needed-

Particulars	Initial date	Year 1	Year 2	year 3	year4	year 5
A.)Number of units produced		40000	46000	52900	60835	69960
(B)Selling price per unit		$250	$255	$260.10	$265.30	$270.60
(C) Total Sales(A*B)		$10000000	$11730000	$13759290	$16139526	$18931176
(D) Total Working capital needed(8%*C)		$800000	$938400	$1100743	$1291162	$1514494
	Initial working capital invested is$350000
Additional working capital needed		=$800000-$350000 =$450000	=$938400-$800000 =$138400	=$1100743-$938400 =$162343	=$1291162-$1100743 =$190419	=$1514494-1291162 =$223332