Question

Case Study:
Trump De Tomato Ltd (TDT) is a company in aquacultural industry specialised in farming of aquatic
organisms. TDT is considering opening a new farm in Sandy Bay. This project would involve the purchase
of 13 hectares land at a price of $1,000,000 (Note that: The land is not subject to depreciation for accounting
and tax purposes). In addition to that, the company will need to purchase eight special equiments which cost
$125,000 each. The equipments are expected to be in use for 5 years and after that, they will be scrapped
without any residual value. Each year, each of these equipments will incur $5,000 maintenance cost. It is
assumed that the farm will first be used at the beginning of the next financial year: 1 July 2022.
Before starting this new operation, TDT will need to redevelop and renovate the warehouse at the farm. This
is expected to cost $200,000. Assume that TDT is not able to claim any annual tax deduction for the capital
expenditure to the renovation of the building until the business is sold.
Revenue projections from the farm for the next five years are as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
Beginning 1/7/2022 1/7/2023 1/7/2024 1/7/2025 1/7/2026
Ending 30/6/2023 30/6/2024 30/6/2025 30/6/2026 30/6/2027
Production quantity (tons) 120 140 170 185 185
Price (per tons) $9,000 $9,150 $9,250 $9,300 $9,350
Operating variable costs associated with the new business including material costs and labour costs.
Estimated material costs per ton in year 1 is $2,000 and this cost will increase by 3.5% every year. The farm
will require about 6 workers working for 8 hours a day, 200 days per year. The pay rate is flat at $20/ hour
including superannuation. Annual operating fixed costs associated with production (excluding depreciation)
are $100,000. Existing administrative costs are $550,000 per annum. As a result of the new operation, these
administrative costs will increase by 30%. The company is subject to a tax rate of 30% on its profits.
Meanwhile, TDT Ltd is currently financed by 60% of equity and 40% of debt. Company’s bond is traded at
a price of $980. The bond has 10 year term, 8% coupon rate paid semi-annually and face value of $1,000. In
addition, company’s equity has a beta of 1.2 while the risk-free rate in the market is 3% and market portfolio
return is estimated to be 12%.
P. De Potato, the company CFO would like you to help him examine the viability of the project for the next
five years, taking into account the projections of sales and operations costs prepared by company’s
accountants.

quesstion 1: Using sensitivity analysis, recalculate NPV using the scenario of a. A decrease in project sales by 10% annually. b. An increase of the sale price by 5% annually c. An increase of material costs change from 3.5% to 8% Briefly comment on your results.

Answer 1

1. Analysis of Viability of projest:

Initial Investment : Cost of Land = 1,000,000

Cost of 8 Machines @ 125000 = 1,000,000

Rennovate and Redevelopment = 200,000

Total = 2,200,000

Calculation of rate of interest using CAPM model = Rf+Beta( Rm-Rf)

3+1.2(12-3) = 13.8%

Calculation of Cash Inflows :

Partuculars	Year 1	Year 2	Year 3	Year 4	Year 5
Producion Qty in Tons(a)	120	140	170	185	185
Price per ton(b)	9000	9150	9250	9300	9350
Total Revenue(a x b)	1080000	1281000	1572500	1720500	1729750
Less: Material Cost @ 2000 with 3.5% increment	2000x120= 240000	2070x140= 289800	2143x170= 364310	2217x185= 410145	2295x185= 424575
Less: Labour Cost 8x6x200x20	192000	192000	192000	192000	192000
Less : Fixed Cost	100000	100000	100000	100000	100000
Less : Additional adminstrative cost 550000x30%	165000	165000	165000	165000	165000
Less : Maintainance cost	5000	5000	5000	5000	5000
Less: Depreciation (125000x8)/5	200000	200000	200000	200000	200000
Net profit before taxes	178000	329200	546190	648355	643178
Less:Taxes @ 30%	53400	98760	163857	194506.5	192952.5
Net Profit after taxes	124600	230440	382333	453848.5	450222.5
Add back Depreciation ( non cash exp)	200000	200000	200000	200000	200000
Net Cash Inflows after taxes	324600	430440	582333	653848.5	650222.5
PV factor @ 13.8%	0.8787	0.7722	0.6785	0.5962	0.5239
PV of cash inflows	285226	332385.8	395112.9	389824.5	340651.6

Total PV of cash inflows = 1743201

NPV = pv of cash inflows - Initial investment

=1743201 - 2200000 = - 456799

Result: It is not viable to start the project as it generate negative NPV i.e. - 456799

2. Sensitivity Analysis:

is as:

a) 10% decrease in Projected sales:

Total Revenue(a x b)	1080000	1281000	1572500	1720500	1729750
Loss due to 10% drop in Sales	108000	128100	157250	172050	172975
Less: Tax saving @ 30%	32400	38430	47175	51615	51892.5
Net Effect on cash flows	75600	89670	110075	120435	121082.5
PV factor @ 13.8%	0.8787	0.7722	0.6785	0.5962	0.5239
PV of Net effect	66429.72	69243.17	74685.89	71803.35	63435.12

Net decrease in NPV = 345597.3

% Change in NPV = 345597.3/456799 = 75.66%

So if there is drop in sales by 10% then NPV further decrease by 75.66%

b) Increase in sale price by 5%

Total Revenue(a x b)	1080000	1281000	1572500	1720500	1729750
5% Increase in sale price	54000	64050	78625	86025	86487.5
Less: Tax @ 30%	16200	19215	23587.5	25807.5	25946.25
Net Increase Effect on cash flows	37800	44835	55037.5	60217.5	60541.25
PV factor @ 13.8%	0.8787	0.7722	0.6785	0.5962	0.5239
PV of Net effect	33214.86	34621.59	37342.94	35901.67	31717.56

Net Increase in NPV = 172798.6

% Change in NPV = 172798.6/456799 = 37.83%

So if there is rise in sale price by 5% then NPV increase by 37.83%

c) Increase in material cost:

Old- Material Cost @ 2000 with 3.5% increment	2000x120= 240000	2070x140= 289800	2143x170= 364310	2217x185= 410145	2295x185= 424575
New- 5% Material Cost @ 2000 with 8% increment	240000	2160x140= 302400	2332.8x170= 396576	2519x185= 466093	2720.5x185= 503296
Net increase in Material cost:	-	12600	32266	55948	78721
Less: Tax @ 30%	-	3780	9679.8	16784.4	23616.3
Net Increase Effect on cash flows	-	8820	22586.2	39163.6	55104.7
PV factor @ 13.8%	0.8787	0.7722	0.6785	0.5962	0.5239
PV of Net effect	-	6810	15324.74	23349.34	28869.35

Net decrease in NPV = 74354.23

% Change in NPV = 74354.23/456799 = 16.28%

So if there is increase in material cost from 3.5% to 8% then NPV further decrease by 16.28%