Question

Synergy is now considering a project to launch a new product called M1. The life of the project is expected to be six years, and the project’s risk is similar to that of the company’s existing operations.
To manufacture M1, a new machine costing $1,200,000 will be required. The machine will be sold at the end of the project, and a $42,000 salvage value is expected.
Production and sales of M1 are expected to be 100,000 units in the first year, 110,000 units in the second year, 120,000 units in the third year, and 125,000 units in each of the remaining three project years. Variable costs of $12 will be incurred for each unit, which can be sold for $19. Incremental fixed cost amounting to $300,000 per year will also be incurred.
Working capital investment required at the beginning of the project is estimated to be 15% of the expected sales revenue in the first year of the project. Thereafter, Synergy will review working capital requirement at the end of each year to determine if the existing level of working capital investment requires adjustment.
In each review, the level of working capital investment considered appropriate will always be 15% of the expected sales revenue in the next year. (For example, in the first review, which will take place at the end of the first year, the level of working capital investment considered appropriate will be equal to 15% of the expected sales revenue in the second year of the project).

The project is expected to use a factory building owned by Synergy. The building is currently unoccupied but recently the company received an offer to rent the building for $55,000 a year for six years. The rental income will not be taxable as it is exempted under a government scheme aimed at encouraging companies to rent out unused factory space.
The risk-free rate is 2.5% per year and the expected return on the market is 10% per year.
The company pays profit tax in the same year at an annual rate of 20%.
Tax allowable depreciation should be ignored.

(1)Evaluate the M1 project using the net present value method and recommend to Synergy whether the project should be launched.

(2)Explain how Synergy could use sensitivity analysis to assist the evaluation of the M1 project. Estimate the two sensitivities below and use them as illustrative examples in your explanations.
i) The sensitivity of the M1 project to M1’s unit selling price.
ii) The sensitivity of the M1 project to the incremental fixed cost.

(3)Synergy would also like to understand more about the limitations of the internal rate of return (IRR) method. Please explain.

Answer 1

product M1

Life = 6 years

New machine cost = $1,200,000

Salvage value = $42,000

year	production and sales	variable cost (12)	sales (19)	fixed cost	revenue
1	100,000	1200000	1900000	300000	400000
2	110,000	1320000	2090000	300000	470000
3	120,000	1440000	2280000	300000	540000
4	125,000	1500000	2375000	300000	575000
5	125,000	1500000	2375000	300000	575000
6	125,000	1500000	2375000	300000	575000

working capital = 15%

building rent = $55,000

risk-free rate = 2.5%

expected return on the market = 10%

tax rate = 20%

(1)

total outflow =  $1,200,000+$55,000=1255000

NPV = present value of cash inflow - present valuue of cash outflow

ioutflow	inflow	present value of 1	present value
1255000
	400000	0.909	363600
	470000	0.826	388220
	540000	0.751	405540
	575000	0.683	392725
	575000	0.620	356500
	575000	0.564	322000

total inflow = 2228585

npv = 2228585-1255000=973585

(2)

the selling price of 19 is more than the variable cost . it hence provide profit of 7per unit (19-12)

incrimental fixed cost is also helping for the increse in revenue because the production and selling unit is incresed by year by year and fixed cost is not incresing it helps in incresing revenue.

(3)

initial inflow	risk free return (2.5%)	tax (20%)	inflow
363600	9090	72720	281790
388220	9705.5	77644	300870.5
405540	10138.5	81108	314293.5
392725	9818.5	78545	304361.5
356500	8912.5	71300	276287.5
322000	8050	64400	249550

irr =( (cash inflow)/ (1+r)^t) - initial investment

= ((1727153) / (1+.10)^6) - 1255000

= ((1727153) / (1.77156) - 1255000

  

irr = inflow - outflow = 0

that means irr is the % when inflow is equal to outflow

irr does not consider important factors like project duration future cost ot the size of a project.it simply compares the project cash inflow to the project existing cost.