Question

Q1. You are the Chief Financial Officer of Tamuda Berhad, a leading Malaysian property
developer. Tamuda Berhad is considering the development of a wireless home
networking appliance, called HomeNet that will provide both the hardware and the
software necessary to run an entire home from any internet connection. In addition to
connecting PCs and printers, HomeNet will control new internet-capable stereos,
digital video recorders, heating and air-conditioning units, major appliances,
telephone and security systems, office equipment, and so on. The major competitor
for HomeNet is a product being developed by Damuda Berhad. Based on extensive
marketing surveys, the sales forecast for HomeNet is 50,000 units per year. Given the
pace of technological change, Tamuda Berhad expects the product will have a fouryear life and an expected wholesale price of RM260. Actual production will be
outsourced at a cost (including packaging) of RM110 per unit. To verify the
compatibility of new consumer internet-ready appliances, as they become available,
with the HomeNet system, Tamuda Berhad must also establish a new lab for testing
purposes. It will rent the lab space, but will need to purchase RM10.5 million of new
equipment. The salvage value of this equipment after year 4 is RM1.8 million. The
equipment will be depreciated using the straight-line method over a five-year life.
Tamuda Berhad’s marginal tax rate is 40% and its weighted average cost of capital is
12%. The lab will be operational at the end of one year. At that time, HomeNet will
be ready to ship. Tamuda Berhad expects to spend RM2.8 million per year on rental
costs for the lab space, as well as marketing and support for this project. At setup,
Tamuda Berhad requires RM500,000 in net working capital which will be recaptured
at the end of the project.
Required:
(a) Generate the relevant cash flows needed to analyze the proposal.

(b) Compute the net present value (NPV) of the proposal.
(c) Calculate the internal rate of return (IRR) of the proposal
(d) Make a recommendation to accept or reject the proposal, and justify your
answer.
(e) Identify the highest cost of capital that the firm could have and still accept the
proposal and defend your answer.

Answer 1

a) Generate the relevant cash flow for analyzing the project.

The following table shows the annual free cash flow for the life of the project (4 years).

Amount in RM	Year 0	Year 1	Year 2	Year 3	Year 4
Sales in Units - A		50,000	50,000	50,000	50,000
Selling price per unit - B		260	260	260	260
Sales - C = AxB		13,000,000	13,000,000	13,000,000	13,000,000
Cost per Unit - D		110	110	110	110
Total Cost - E = AxD		5,500,000	5,500,000	5,500,000	5,500,000
Lab rent cost - F		2,800,000	2,800,000	2,800,000	2,800,000
Depreciation (Note 1) - G		2,100,000	2,100,000	2,100,000	2,100,000
Earnings Before Tax (C-E-F-G)		2,600,000	2,600,000	2,600,000	2,600,000
Less: Tax @40%		1,040,000	1,040,000	1,040,000	1,040,000
Profit After Tax		1,560,000	1,560,000	1,560,000	1,560,000
Add: Depreciation		2,100,000	2,100,000	2,100,000	2,100,000
Cash Flow - H	-	3,660,000	3,660,000	3,660,000	3,660,000
Working Capital for cash flow - I	(500,000)				500,000
Plant & Equipment - J	(10,500,000)				1,800,000
Free cash flow H+I+J	(11,000,000)	3,660,000	3,660,000	3,660,000	5,960,000

Note: Depreciation = Cost of the Equipment/life of the equipment.

Depreciation = 10,500,000/5 = 2,100,000

b) Find the Net Present Value (NPV).

NPV can be found out by discounting the above free cash flow with its discounting factor (which is cost of capital of 12% in this case).

Year	Free cash flow - A	Discounting Factor @12% - B	PV - AxB
Year 0	(11,000,000)	1	(11,000,000)
Year 1	3,660,000	0.893	3,267,857
Year 2	3,660,000	0.797	2,917,730
Year 3	3,660,000	0.712	2,605,116
Year 4	5,960,000	0.636	3,787,688
		NPV (Sum)	1,578,390

Discounting factor = 1/(1+i)^n
i = Discounting rate (in this case 12%)
n = Period (in thi case 1 to 4).

c) Calculate IRR.

Internal Rate of Return (IRR) can be computed using IRR formula in excel [=IRR(year1 cashflow, year2 cashflow...). Alternatively, it can be found using trial and error method. While calculating IRR, the Free cash flow as mentioned in question a) to be used.

Based on the Free cash flow, IRR for this project is 18%.

d) Recommendation for the project.

Based on the above NPV and IRR workings it is advisable that Tamuda Berhad accept the Project. Since the NPV is positive and IRR is above the cost of capital (or expected returns) the project is viable.

e)  Identify the highest cost of capital that the firm could have and still accept the proposal?

The firm can accept the project as long as the NPV is zero or above. At IRR, the NPV will be zero. Hence, the cost of capital can raise upto the IRR and still the project can be accepted.

Hence, the highest cost of capital that the firm could have and still go ahead with the proposal is 18%.