Question

East West Bearings Ltd wants to expand its operations in Geelong. Considering the competitive environment and macro uncertainty, East West wants to make sure that they should invest professionally so that they would not suffer either on account of profits or on account of cash flows on any project. As the sales are growing consistently, to meet the projected sales, East West wants to set up a new plant to manufacture bearings. In this regard, the director of East West approaches you for your suggestions on their capital budgeting decision to set up a new bearings manufacturing plant. The initial investment includes cash outlays for plant of $2 million, for equipment of $700,000, and for working capital of $300,000. Working capital will be deployed at initial stage and will be released at the end of the project. Project once started its cash revenue is projected worth $1.1 million for each of the 10 years of the project. Fixed cash expenses for this plant are $250,000 for each year. Variable cash expenses are $350,000 for first eight years of the operation, then in year 9 and 10 these become $360,000 for each of these years. East West sells 50,000 bearings every year, starting from year 1 to year 10. Each bearing is sold for a price of $22 in all 10 operational years. Plant will be depreciated on a straight-line basis for 10 years. Equipment will be depreciated at a rate of $70,000 per annum for 10 years of operation. Corporate tax is levied at the rate of 30% per annum. At the expiry of 10 years, plant carries market value of $800,000 and is sold at this price while equipment is sold for $100,000. Working capital will be released at the expiry date. East West Bearings has a company policy to use 7% as the hurdle rate for all expansion investment opportunities. The hurdle rate is based on the study of the company’s cost of capital conducted 3 years ago.

a. Prepare cash flow statement/s and compute the NPV and IRR of the proposed project. Comment on the feasibility of the project.

Answer 1

Depriciation Of Plant is Calculated as :

(Initial Value-Scrap Value)/Number of Years= $(2000000-800000)/10=$120000

Depriciation of machinery is $70000

Total Depriciation =$(120000+70000)=$190000

IRR is calculated at 7% discount rate.

Since, NPV is positive and IRR(9.72%) is greater than the required rate of return (7%), the project is feasible