Question

USIL Company has developed a new detergent that can be sold for KES 350 per unit. The company has undertaken market research at a cost of KES 12 million in order to forecast the future cash flows of the investment project. The detergent is expected to continue gaining popularity for many years. The Chief Finance Officer has, however, proposed that investment in the new product should be evaluated over a four-year time-horizon, (even though sales would continue after the fourth year), on the grounds that cash flows after four years are too uncertain to be included in the evaluation. The variable and fixed costs (both in current price terms) are as follows:

Sales volume (units)	Less than 1 million	1 to 1.9 million	2 to 2.9 million	3 to 3.9 million
Variable cost (KES per unit)	250	270	280	300
Total fixed cost (KES)	5 million	5. 8 million	6.8 million	7.8 million

The forecasted sales volumes are as follows:

Year	1	2	3	4
Demand (units)	700,000	1,200,000	1,600,000	2,200,000

The machinery required for production of the new detergent line would cost KES 200 million. An additional initial investment of KES 125 million will be needed for working capital. Plato Manufacturing Company pays corporate tax at the rate of 30% per year, payable one year in arrears. Selling price and cost information are in current price terms, before applying selling price inflation of 6% per year, variable cost inflation of 4 % per year and fixed cost inflation of 6% per year.

USIL Company uses an after-tax cost of capital of 14% to appraise all new capital projects. Assume that production lasts for only the four years under consideration above, calculate the NPV of investing in the new machine and advice if it’s financially acceptable (work to two decimal places).

Answer 1

		Cost of Market Research is a Sunk Cost
		It is not relevant for this analysis
		Present Value(PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=discount rate=cost of Capital=14%=0.14
		N=Year   of Cash Flow
	N	Year	0	1	2	3	4
		INITIAL CASH FLOW
	a	Machinery	(200,000,000)
	b	Working Capital	-125000000
	I=a+b	Total Initial Cash Flow	-325000000
		ANNUAL CASH FLOW
	c	Demand in units		700,000	1,200,000	1,600,000	2,200,000
	d	Price per unit(after adjusting for inflation of 6%)		350	371	393	417
	e	Unit Variable Cost (after adjusting for inflation4%)		250	281	292	315
	f=d-e	Unit Contribution Margin		100	90	101	102
	g=c*f	Total Contribution Margin		70,000,000	108,240,000	161,964,800	224,166,096
	h	Fixed Costs (after adjusting for 6% inflation)		5,000,000	6,148,000	6,516,880	8,098,909
	i=g-h	Before Tax Profit		65,000,000	102,092,000	155,447,920	216,067,187
	X=i*(1-0.3)	Annual After tax Cash Flow		45,500,000	71,464,400	108,813,544	151,247,031
	T	Terminal Cash Flow(Release of working capital)					125,000,000
	CF=I+X+T	Net Cash Flow	(325,000,000)	45,500,000	71,464,400	108,813,544	276,247,031	SUM
	PV=CF/(1.14^N)	Present Valure	(325,000,000)	39,912,281	54,989,535	73,446,043	163,560,419	6,908,277.48
	NPV =Sum of PV	Net Present Value(NPV)	6,908,277.48
		It is Financially acceptable
		NPV is positive