Question

Plato Manufacturing Company has developed a new detergent that can be sold for KES 350 per unit. The company has undertaken market research at a cost of KES 12 million in order to forecast the future cash flows of the investment project. The detergent is expected to continue gaining popularity for many years. The Chief Finance Officer has, however, proposed that investment in the new product should be evaluated over a four-year time-horizon, (even though sales would continue after the fourth year), on the grounds that cash flows after four years are too uncertain to be included in the evaluation. The variable and fixed costs (both in current price terms) are as follows:

Sales volume (units)	Less than 1 million	1 to 1.9 million	2 to 2.9 million	3 to 3.9 million
Variable cost (KES per unit)	250	270	280	300
Total fixed cost (KES)	5 million	5. 8 million	6.8 million	7.8 million

The forecasted sales volumes are as follows:

Year	1	2	3	4
Demand (units)	700,000	1,200,000	1,600,000	2,200,000

The machinery required for production of the new detergent line would cost KES 200 million. An additional initial investment of KES 125 million will be needed for working capital. Plato Manufacturing Company pays corporate tax at the rate of 30% per year, payable one year in arrears.

Selling price and cost information are in current price terms, before applying selling price inflation of 6% per year, variable cost inflation of 4 % per year and fixed cost inflation of 6% per year. Plato Manufacturing Company uses an after-tax cost of capital of 14% to appraise all new capital projects.

Assume that production lasts for only the four years under consideration above, calculate the NPV of investing in the new machine and advice if it’s financially acceptable (work to two decimal places).

Answer 1

Year	0	1	2	3	4
a.Initial investment	-200000000
b.NWC introd. & recovered	-125000000				125000000
Operating Cash flows:
1.Sales volume		700,000	1,200,000	1,600,000	2,200,000
2.S.P/unit		371	393.26	416.86	441.87
3.Sales $ (1*2)		259700000.00	471912000.00	666968960.00	972107259.20
4. Variable cost/unit		260	292.032	303.71	327.56
5. Total var.cost(1*4)		182000000.00	350438400.00	485941248.00	720632872.96
6. Fixed costs		5300000.00	6516880.00	6907892.80	8584843.33
7.EBT(3-5-6)		72400000.00	114956720.00	174119819.20	242889542.91
8. Tax at 30%( to pay one yr. in arrears)			21720000.00	34487016.00	52235945.76
9.EAT(7-8)		72400000.00	93236720.00	139632803.20	190653597.15
10.Depn. Tax shields(200000000/4*30%)		15000000	15000000	15000000	15000000
11. OCF		87400000.00	108236720.00	154632803.20	205653597.15
12.Total annual C/fs(a+b+11)	-325000000	87400000.00	108236720.00	154632803.20	330653597.15
13. PV F at 14%(1/1.14^Yr.n)	1	0.87719	0.76947	0.67497	0.59208
14. PV at 14%(12*13)	-325000000	76666666.67	83284641.43	104372737.63	195773473.52
15. NPV(Sum of Row 14)	135097519.24
RECOMMENDATION:
Investing in the new machine is financially acceptable---
as the NPV is POSITIVE

Workings for
Year	0/ Current	Inflation %	1		2		3		4
2.Selling price /unit	$350	6%	350*1.06=	371	371*1.06=	393.26	393.26*1.06=	416.86	416.86*1.06=	441.87
4.Variable cost/unit	$ 250/270/270/280	4%	250*1.04=	260	270*1.04^2=	292.03	270*1.04^3=	303.71	280*1.04^4=	327.56
6. Fixed costs	$ 5/5.8/5.8/6.8 mln.	6%	5000000*1.06=	5300000	5800000*1.06^2=	6516880	5800000*1.06^3=	6907892.80	6800000*1.06^4=	8584843.33