Question

Njenge is a special purpose vehicle set up by the Football Association of Zambia (FAZ) and the National Sports Council of Zambia (NSCZ) to undertake a project to manufacture an innovative muscle toning

device (Muleza) that will be used in the treatment of sporting injuries. It is expected that the commercial life of the Muleza will be four years after which technological advances will bring more sophisticated devices to the market and the sales will fall to virtually zero. K8, 000,000 has been spent in developing and testing the device over the past year. Initial market research has been conducted at a cost of K2, 500,000 and is due to be paid shortly. The market research indicates the following demand and selling price per unit:

Year (from now)                        2                     3                      4                      5

Units demand                            2,000                70,000              125,000             20,000

Selling Price                              K2, 000             K2,200              K1,600              K1,400

A factory will be built for the production of the Muleza for K30, 000,000 and will take a year to complete. Payment will be made in two installments; the first installment of K18, 000,000 is payable immediately and the remainder in a year’s time. The factory building is expected to be sold for K25, 000,000 when the production and sales cease.

Machinery costing K16, 000,000 will be installed at the end of the first year. The machinery will be depreciated on a straight-line basis over the next four years and is expected to have a nil value at the end of the four years.

At present the materials cost of making one Muleza unit is K700. Njenge has enough materials in stock to make 1,500 units, which it had purchased a year ago for K450 per Muleza unit. If the project does not go ahead then these materials will be sold for an equivalent of K120 per Muleza unit.

Labour that will be used to make the Muleza is to be made redundant immediately at a cost of K2,000,000 if the project does not go ahead. Labour costs per unit are K250. It is expected that once the project is completed, the labour will be made redundant at a cost of K3, 500,000.

Fixed production overheads relating specifically to the production of the Muleza are expected to be K13,000,000 per annum and variable production overheads are expected to be K150 per Muleza unit produced and sold. Administrative costs are expected to be K17, 000,000 per annum of which K5,500,000 is allocated from the head office and the remainder relates directly to the production of the Muleza.

Working capital of K10,000,000 will be required at the beginning of the second year once the production and sales have commenced. This will be released when the production and sales cease.

The relevant cost of capital for the project is 9%.

Assume that all cash flows occur at the year- end unless stated otherwise. All workings should be in K’000s to the nearest K’000. Ignore tax and inflation.

Required:

(a) Calculate the net present value and internal rate of return of the project and recommend whether the Muleza should be produced. Provide a brief justification of the cash flows included and excluded in the calculations.                                                                   

Answer 1

		K 8 million spent on developing and testing is a sunk cost and not relevant
		K 2.5 million on market research is a committed cost and not relevant for this analysis
		Present Value(PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=discount rate =Cost of Capital=9%=0.09
		N=Year   of Cash Flow
		Direct material cost in year 2
		For 1500 units Opportunity cost=1500*150	225000
		For balance 500 units, cost=500*700	350000
		Material cost in year 2=225000+350000	575000
		Material cost in year 3	49000000	(70000*700)
		Material cost in year 4	87500000	(125000*700)
		Material cost in year 5	14000000	(20000*700)
		Annual Depreciation expense (16000000/4)	4000000	(Depreciation is a non cash expense. Since tax is ignored, there is no depreciation tax shield)
			(All Figures in 000 K)
		CASH FLOW ANALYSIS OF THE PROJECT
	N	Year	0	1	2	3	4	5
	a	Cash Flow to built factory	(18,000)	(12,000)
	b	Cash Flow for Machinery purchase		(16,000)
	c	Cash Flow for Working Capital		(10,000)
	d	Annual Demand in units			2,000	70,000	125,000	20,000
	e	Selling Price per unit (K000)			2.0	2.2	1.6	1.4
	f=d*e	Annual Sales Revenue			4,000	154,000	200,000	28,000
	g	Annual Materials Costs			(575)	(49,000)	(87,500)	(14,000)
	h	Savings in cost of labor redundancy	20,000
	i=d*0.25	Annual Labor Cost			(500)	(17,500)	(31,250)	(5,000)
	j=d*0.15	Variable Production Overhead			(300)	(10,500)	(18,750)	(3,000)
	k	Fixed Production Overhead			(13,000)	(13,000)	(13,000)	(13,000)
	l	Administrative Expense(17000-5500)			(11,500)	(11,500)	(11,500)	(11,500)
	M=f+g+h+i+j+k+l	Operating Cash Flow	20,000	-	(21,875)	52,500	38,000	(18,500)
		Terminal Cash Flow:
	p	Salvage value of factory						25,000
	q	Release of initial working capital				-		10,000
	r	Terminal Labor redundancy cost				-		(3,500)
	T=p+q+r	Total Terminal Cash Flow						31,500
	CF=a+b+c+M+T	Net Cash Flow	2,000	(38,000)	(21,875)	52,500	38,000	13,000	SUM
	PV=CF/(1.09^N)	Present Value of Net Cash Flow	2,000	(34,862)	(18,412)	40,540	26,920	8,449	24,635
	NPV=Sum of PV	Net Present Value(NPV)	K 24,635,000
		Internal Rate of Return	30.80%
		(Using IRR function of excel)