Question one SC Co is evaluating the purchase of a new machine to produce product P...

Question one

SC Co is evaluating the purchase of a new machine to produce product P , Which has a short product life-cycle due to rapidly changing technology .The machine is expected to cost $1 million . Production and sales of product P are forecast to be as follows :

Year	1	2	3	4
Production and sales (units/year)	35000	53000	75000	36000

The selling price 0f product P (in current price terms )will be $20 per unit, while the variable cost of the product (in current price terms )will be $12 per unit .Selling price inflation is expected to be 5% per year. No increase in existing fixed costs is expected since SC co has spare capacity in both spare and labourterms .

Production and selling product P will call for increased investment in working capital . Analysis of historical levels of working capital within SC Co indicates that at the start of each year , investment in working capital for product P will be need to be 7% of sales revenue for that year .

SC Co pays tax of 30% per year in the year in which the taxable profit occurs ,liability to tax is reduced by capital allowances on machinery (tax –allowable depreciation ) , which SC Co can claim on a straight –line basis over the four-year period .SC Co uses a nominal (money terms ) after-tax cost of capital of 12% for investment appraisal purposes.

Required :

Determine the after –tax cash-flows associated with the purchase of a new machine to purchase product P .(12) marks
Calculate the net present value of the proposed investment in product P.(6) marks
Compute the internal rate of return of the proposed investment in product P.(6)marks
Advise on the acceptability of the proposed investment in product P and discuss the limitations of the evaluations you have carried out.(8)marks
Discuss hoe the net present value method of investment appraisal contributes towards the objective of maximizing the wealth of shareholders .(8)marks

Solutions

Expert Solution

NPV analysis using a nominal (money terms ) after-tax cost of capital of 12%
Year	0	1	2	3	4
1.Cost of machine	-1000000
2.NWC reqd.(Next yr. sales*7%)	51450	81805.5	121550.6	61261.52	0
3.Change in NWC(Previous-Current)	-51450	-30355.5	-39745.1	60289.11	61261.52

Operating cashflows:
4.Production and sales (units/year)		35000	53000	75000	36000
5.Selling price/unit(20*1.05)$ so on		21	22.05	23.1525	24.31013
6.Sales $(4*5)		735000	1168650	1736438	875164.5
7.Variable cost/unit(12*1.05)& so on		12.6	13.23	13.8915	14.58608
8.Total variable cost(4*6)		-441000	-701190	-1041863	-525099
9.Depreciation		-250000	-250000	-250000	-250000
10.EBIT(6+8+9)		44000	217460	444575	100065.8
11.Tax at 30%(10*30%)		-13200	-65238	-133373	-30019.7
12.NOPAT(10+11)		30800	152222	311202.5	70046.06
13.Add back: depn.(row 9)		250000	250000	250000	250000
14.Operating cash flow(12+13)		280800	402222	561202.5	320046.1

a. After –tax cash-flows associated with the purchase of a new machine	-1051450	250444.5	362476.9	621491.6	381307.6
16. PV F at 12%(1/1.12^Yr.n)	1	0.89286	0.79719	0.71178	0.63552
17. PV at 12%(a*16)	-1051450	223611.2	288964.3	442365.5	242327.9
18. NPV at 12% (ANSWER b. )	145818.82
19. Internal rate of return (Answer c.)(of FCF row a.)	17.82%

d.Proposed investment in product P can be accepted as the NPV at the nominal cost of capital, 12% is POSITIVE

&the IRR, 17.82% > the nominal cost of capital, 12%

Limitation , with respect to the above analysis , is that it considers all the future cashflows like sales & variable costs at inflated values & not at their real value terms.

e.How the net present value method of investment appraisal contributes towards the objective of maximizing the wealth of shareholders

NPV method takes into account the entire cash flows of the project , discounts them at the cost of acquring funds for the project and arrives at the net income , at present value terms.

So, the project with positive cash flow , is said to add value to the company & its owners.

Additionally for d.

The real discount rate will be

(1+12%)=(1+Real rate )*(1+5%)

RR=((1+12%)/(1+5%))-1=

6.67%

NPV analysis using the real rate of 6.67% cost of capital
Year	0	1	2	3	4
1.Cost of machine	-1000000
2.NWC reqd.(Next yr. sales*7%)	49000	74200	105000	50400	0
3.Change in NWC(Previous-Current)	-49000	-25200	-30800	54600	50400

Operating cashflows:
4.Production and sales (units/year)		35000	53000	75000	36000
5.Selling price/unit--current rate-$20		20	20	20	20
6.Sales $(4*5)		700000	1060000	1500000	720000
7.Variable cost/unit--current rate -$ 12		12	12	12	12
8.Total variable cost(4*6)		-420000	-636000	-900000	-432000
9.Depreciation		-250000	-250000	-250000	-250000
10.EBIT(6+8+9)		30000	174000	350000	38000
11.Tax at 30%(10*30%)		-9000	-52200	-105000	-11400
12.NOPAT(10+11)		21000	121800	245000	26600
13.Add back: depn.(row 9)		250000	250000	250000	250000
14.Operating cash flow(12+13)		271000	371800	495000	276600

a. After –tax cash-flows associated with the purchase of a new machine	-1049000	245800	341000	549600	327000
16. PV F at 6.67%(1/1.0667^Yr.n)	1	0.93747	0.87885	0.82390	0.77238
17. PV at 6.67%(a*16)	-1049000	230430.3	299688.3	452814	252568.1
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Question one SC Co is evaluating the purchase of a new machine to produce product P...

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