Question

Dysxa Co is looking to expand the capacity of an existing factory in its Alpha Division by 850,000 units per year in order to meet increased demand for one of its products. The expansion will cost $3.2 million.

The selling price of the product is $3.10 per unit and variable costs of production are $1.10 per unit, both in current price terms. Selling price inflation of 3% per year and variable cost inflation of 6% per year are expected. Nominal fixed costs of production have been forecast as follows:

Year	1	2	3	4
Fixed costs ($)	110,000	205,000	330,000	330,000

Dysxa Co has a nominal after-tax weighted average cost of capital of 10% and pays corporation tax of 20% per year one year in arrears. The company can claim 25% reducing balance tax-allowable depreciation on the full cost of the expansion, which you should assume is paid at the start of the first year of operation.

Dysxa Co evaluates all investment projects as though they have a project life of four years and assumes zero scrap value at the end of four years.

Question

1. Calculate the net present value of the investment project and comment on its financial acceptability.

2. Dysxa Co has limited the capital investment funds in its Delta Division to $7m. The division has identified five possible investment projects, as follows:

Project	Initial Investment ($)	Net present value ($)
A	3,000,000	6,000,000
B	2,000,000	3,200,000
C	1,000,000	1,700,000
D	1,000,000	2,100,000
E	2,000,000	3,600,000

These projects are divisible and cannot be deferred or repeated. Projects C and E are mutually exclusive. Determine the net present value of the optimum investment schedule for Delta Division.

3. Discuss the reasons why hard and soft capital rationing occur.

4. Discuss TWO ways in which the risk of an investment project can be assessed.

Answer 1

1)

Statement showing depreciation

Year	Opening balance	Depreciation	Closing balance
1	3200000	800000	2400000
2	2400000	600000	1800000
3	1800000	450000	1350000
4	1350000	337500	1012500

Statement showing NPV

Particulars	0	1	2	3	4	NPV
Cost of Expansion	-3200000
SPPU		3.1	3.193	3.28879	3.3874537
VCPU		1.1	1.166	1.23596	1.3101176
CPU		2	2.027	2.05283	2.0773361
No of units		850000	850000	850000	850000
Total contribution		1700000	1722950	1744906	1765736
Fixed cost		110000	205000	330000	330000
Depreciation		800000	600000	450000	337500
PBT		790000	917950	964905.5	1098236
Less: Tax @ 20%		158000	183590	192981.1	219647
PAT		632000	734360	771924	878589
Add: depreciation		800000	600000	450000	337500
Cash flow		1432000	1334360	1221924	1216089
Total cash flow	-3200000	1432000	1334360	1221924	1216089
PVIF @ 10%	1	0.909	0.826	0.751	0.683
Present value	-3200000	1301818	1102777	918050	830605	953250

2) Statement showing ranking Based on PI

Project	Initial Investment	NPV	PV of cash inflow	PI = PV of cash inflow/PV of cash outflow	Rankings
A	3000000	6000000	9000000	3.000	2
B	2000000	3200000	5200000	2.600	5
C	1000000	1700000	2700000	2.700	4
D	1000000	2100000	3100000	3.100	1
E	2000000	3600000	5600000	2.800	3

Thus project to be selected

= D,A and E