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Mount Elgon Ltd. is considering the launch of a new product Excel, for which an investment...

  1. Mount Elgon Ltd. is considering the launch of a new product Excel, for which an investment of Shs. 6,000,000 in plant and machinery will be required. The production of Excel is expected to last five years after which the plant and machinery would be sold for Shs.1,500,000.

Additional information:

  1. Excel would be sold at Sh600 per unit with a variable cost of Sh240 per unit.
  2. Fixed production costs (excluding depreciation) would amount to Shs. 600,000 per annum.
  3. The company applies the straight line method of depreciation.
  4. The cost of capital is 10% per annum.
  1. The units of Excel expected to be sold per annum for the next five years are shown below:

YEAR

Unit Expected to be Sold

1

8,000

2

7,000

3

7,000

4

5,000

5

3,000

The corporation tax rate is 30%.6.

Required:

  1. Calculate the net present value (NPV) of the project and advise the management on the appropriate course of action.
  2. Calculate the internal rate of return (IRR) of the project and advise the management on the appropriate course of action.
  3. Outline the main drawbacks of the IRR method of investment appraisal.

Solutions

Expert Solution

We have assumed that cost of asset is deprecated net of salvage value, if we choose to depreciate entire cost over life, Post tax Salvage value of asset should be computed as follows -

= Salvage value x (1-tax rate)

Disadvantages of IRR

It does not give consideration to Size of project, timings of cashflows and life of the project.

IRR also ignores reinvestment rate and only consider the future Value of cashflows occuring at a time.

jeff jeffy answered 1 year ago
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