Question

The management team of Accent Group Limited have received a proposal from the manager of Hype DC. This proposal concerns a major upgrade to Hype DC's stores to improve the customer experience. Key details relating to this proposal include:

• The initial cost will be $22 million. This cost will be depreciated using the straight line method over the 5 year life of the upgrade.
• During year 1, the firm will increase marketing costs by $2.0 million to promote the store upgrades.
• Over the five year life of the project, it is expected that the upgrade will increase the firm's sales by $18 million per year. On average, cost of sales is 45% of revenue.
• The firm will need to higher additional staff over the life of the project to help to deal with the increased sale volume. In year 1, the firm's staffing costs will increase by $1.0 million. These costs will increase by 3.5% p.a.
• The upgrade is expected to increase the firm's energy costs by $500,000 in year 1. This increase will be ongoing across the life of the project and will increase by 6% p.a.
• Upgraded stores will include an old shoe recycling drop off zone. This recylcing program will cost $75,000 in year 1. These costs will increase by 2% p.a.
• At the end of year 3, the firm will spend $1.5 million on a minor refurbishment to the stores.

The firm’s tax rate is 30%. The firm requires a 16% required rate of return on all potential investments.

1. Provide an overview of the key environmental and social factors that the firm should consider in evaluating the proposal
2. Discuss how sensitive your recommendations are to changes in assumptions in regards to the financial impact of the new capital investment. In your discussion, include examples which illustrate how changes to at least two assumptions impact the financial analysis .

Answer 1

Calculation of Net Present Value (NPV) of the project-

Year	Sales	Cost of sales	Increase in marketing cost	Depreciation	Increase in staff cost	Increase in energy cost	Recycling cost	Refurbishment	Profit before tax	Tax @30%	Profit after tax	Add back depreciation	Cash flow after tax	PV @16%	PV of Cash flow after tax
1	18000000	8100000	2000000	4400000	1000000	500000	75000	-	1925000	577500	1347500	4400000	5747500	0.862069	4954741.38
2	18000000	8100000	-	4400000	1035000	530000	76875	-	3858125	1157437.5	2700687.5	4400000	7100687.5	0.7431629	5276967.52
3	18000000	8100000	-	4400000	1070000	560000	78750	1500000	2291250	687375	1603875	4400000	6003875	0.6406577	3846428.59
4	18000000	8100000	-	4400000	1105000	590000	80625	-	3724375	1117312.5	2607062.5	4400000	7007062.5	0.5522911	3869938.24
5	18000000	8100000	-	4400000	1140000	620000	82500	-	3657500	1097250	2560250	4400000	6960250	0.476113	3313865.62
Total									15456250		10819375		32819375		21261941.3

NPV = PV of cash inflow - PV of cash outflow

= 21261941 - 22000000

= $ -738059

When we look after the project we can see that this project will increase employment which is good as per social concern, and also this project require recycling of shoe which is good as per environmental concern.

But when we see this project with respect to financial impact, we can see that this project has negative NPV, therefore this project should be rejected by management.

Assumption 1 - When Rate of return is 13%

With 13% rate of return the PV of cash inflow will be $22883457 and accordingly NPV would be-

= 22883457 - 22000000

= $883457

Assumption 2 - MACRS method is used for depreciation

Year	Rate of Depreciation	Depreciation
1	22	4840000
2	35	7700000
3	19.96	4391200
4	11.52	2534400
5	11.52	2534400

By using MACRS method PV of cash flow will be 21534197 and accordingly NPV would be-

= 21534197 - 22000000

= $ -465803