Question

Somme plc (Somme) is considering an investment project which requires an initial investment in machinery of HK$40 million, payable at the start of the first year of operation. At the end of three years this machinery will be traded in for HK$3,000,000 and if demand for the product is still strong new machinery will be purchased.

The initial HK$40 million investment will attract capital allowances at a rate of 20% per annum on a reducing balance basis. The rate of corporation tax is 25% per annum and any tax liabilities are paid in the year after they arise.

Market research has been carried out, at a cost of HK$500,000, to determine the selling price and the sales and production volumes that are likely to be achieved in the first three years of the project. These have been forecasted as follows:

Year	1	2	3
Sales and production (units)	150,000	250,000	300,000
Selling price per unit at year zero values	HK$250	HK$300	HK$350

These selling prices are expected to be subject to annual inflation of 4%.

Based on the sales and production volumes above, the current value of production costs and overheads have been forecasted as follows:

Year	1	2	3
	Current Values at Year Zero
Production costs	HK$25,500,000	HK$42,500,000	HK$51,000,000
Total overhead costs	HK$11,000,000	HK$11,000,000	HK$11,000,000

Total overhead costs include HK$ 9 million which are only incurred if the project goes ahead.

Production costs and incremental project overheads are expected to be subject to annual inflation of 5%.

The project will require inventory of HK$1,000,000 to be purchased before the project becomes operational. This will be subject to inflation of 5% per annum and will be released at the end of the project.

Somme use a nominal (money) after-tax discount rate of 11% per year to evaluate their capital investments.

Required:

1. Calculate the net present value of the project. You must include all assumptions and show all workings.

2. Using the results above and relevant theories discuss how the project should impact on the value of the company. Your answer should include a discussion on the role of the Efficient Markets Hypothesis in this area.

Now assume that the new project will allow Somme to enter a new market with a new product.

Required:

3. Relating to this project describe in detail how you would conduct a probability analysis and a sensitivity analysis and evaluate the difficulties in using each of these methods when helping Somme assess the risk of the project.

Answer 1

Capital Investment	40000000
Investment in Working Capital in year 0	1000000
Salvage Value	3000000
Inflation rate on wkg capital, production overhead, project overhead costs	5%
Inflation rate on Selling Price	4%
Corporate tax rate	25%
Discount rate	11%

Capital allowance schedule	1	2	3
Beginning book value	40000000	32000000	25600000
Depreciation rate	20%	20%	20%
Depreciation amount	8000000	6400000	5120000
Ending Book Value	32000000	25600000	20480000

	1	2	3
# units	150000	250000	300000
Selling price	260	324	394
Sales	39000000	81120000	118110720
Production cost (without inflation)	25500000	42500000	51000000
Production cost (with inflation)	26775000	46856250	59038875
Incremental project overhead (without inflation)	9000000	9000000	9000000
Incremental project overhead (with inflation)	9450000	9922500	10418625

Cash flow analysis	0	1	2	3
1. Initial Cash Flow
Capital Investment	-40000000
Increase in Working Capital	-1000000	-50000	-50000	-50000
2. Operating Cash Flows
Sales		39000000	81120000	118110720
Production cost (with inflation)		26775000	267000	267000
Incremental project overhead (with inflation)		9450000	180000	180000
Capital allowance		8000000	6400000	5120000
Pretax profit		-5225000	74273000	112543720
Tax		0	18568250	28135930
Profit after Tax		-5225000	55704750	84407790
Cash Flow (PAT + Dep)		2775000	62104750	89527790
3. Terminal Cash flow
Working Capital				1150000
Salvage Value				3000000
Net Cash flow (1+2+3-4)	-41000000	2725000	62054750	93627790
NPV	80279815

(1) NPV of the project is HK $80,279,815

(2) The value of the company increases by the same amount as NPV of the project. According to Efficient Market Hypothesis, all investors have complete information and the investors have already priced in the positive NPV that the project would generate, and hence the increase in value of the firm is immediately reflected in the increase in stock price of the company.

(3) The sensitivity analysis can be carried out by varying certain cash flow assumptions like the costs involved with the project (actual costs might turn out to be higher than initially estimated), no. of units sold (actual volume sales might be higher or lower) etc. and their impact on NPV of the project.