Question

*I am seeking an answer to Question 1 B.*

ABC company is considering producing a new range of smartphones that will require it to build a

new factory. Feasibility studies have been done on the factory which cost $5 million. The studies

have found the following:

1. The factory will cost $25 million and will have a useful life of 20 years.

2. The land where the factory will go is currently used as a carpark for workers and it is assumed that the company will have to pay $200000 per year for their workers to park in a nearby carpark.

3. The factory will be depreciated on a straight line basis and will have a salvage value of $0 but it is believed that most of it can be sold for scrap after 20 years for $50000.

4. Due to the nature of the business they are in, they will have to perform some environmental tests to make sure that some of the chemicals they are using are not entering the ground water around the factory. These tests will be performed every 5 years and cost $625000.

5. Through the building of this factory and the selling of the phones it produces, it’s revenue will increase by $5 million in year 1 and remain at this level for the operational life of the factory.

6. The extra costs that the company accrues per year due to the project are $435000 for labour, $50000 for overhead like power and water bills and marketing costs for the new line of phones will be $500000 per year but will decrease by $15000 per year as the phone gains greater penetration.

7. The company’s current cost of capital is 8% per year.

8. The tax rate is 30%.

9. The project requires an initial investment in working capital of $1000000 that is returned

   in year 20.

Use the above information to answer the following (IN EXCEL):

A. Calculate the free cash flows that come from this project for the 20 years it is operational. ​

B. Calculate the NPV, IRR and payback period of the project. Should they go ahead with the project?

Answer 1

1.B Calculate the NPV, IRR and payback period of the project. Should they go ahead with the project?

Calculation of Operating Cash Flows:

Calculation of NPV, IRR and Payback:

NPV = $4,116,483

IRR = 10.03%

Payback period = 8.6 years

Since the NPV is positive and IRR is greater than cost of capital, they can go ahead with the project.

Workings:

Notes:

1. Feasibility studies cost of $5 million is sunk cost and doesnt influence the future cash flows and hence not considered in calculations.

2. Cumulative annual cash flows turns positive between year 8 and 9. Thus payback period is after 8 years.