Question

2. he Beijing Hat Company (BHC) has a project to produce white summer hats with an English rose motif. The initial investment is £37 million and the project will last 10 years. The revenue in each year from year 1 to year 10 will be £26 million but the costs, which will be £10 million in year 1, will then grow by 17% each year over the life of the project. (This means that the costs in year 2, for example, will be 17% higher than the costs in year 1, the costs in year 3 will be 17% higher than the costs in year 2, etc.). BHC does not pay tax and the cost of capital for the project is 5% per year.

   1. Compute the free cash flows (FCFs) on the project.

   2. (5marks)BHC usually employs the internal rate of return(IRR)to assess projects. Under what circumstances is IRR a reliable rule for judging whether a project should be accepted?

   3. What are the problems in using IRR to decide whether BHC’s summer hat project should go ahead?

   4. Should BHC go ahead with the project?

Answer 1

Cost computation

Year	1	2	3	4	5	6	7	8	9	10
Cost for year 1 / Previous year closing cost	10.00	10.00	11.70	13.69	16.02	18.74	21.92	25.65	30.01	35.11
Increase in cost (%)		17%	17%	17%	17%	17%	17%	17%	17%	17%
Increase in cost (Mn)		1.70	1.99	2.33	2.72	3.19	3.73	4.36	5.10	5.97
Cost per year	10.00	11.70	13.69	16.02	18.74	21.92	25.65	30.01	35.11	41.08

Computation of Free cashflows

Year	1	2	3	4	5	6	7	8	9	10
Revenue	26.00	26.00	26.00	26.00	26.00	26.00	26.00	26.00	26.00	26.00
Cost	10.00	11.70	13.69	16.02	18.74	21.92	25.65	30.01	35.11	41.08
Free Cashflows	16.00	14.30	12.31	9.98	7.26	4.08	0.35	(4.01)	(9.11)	(15.08)

IRR is generally used a selecting criteria incase of a hurdle rate or a threshold rate is identified for project evaluation. In this case if IRR of the project is higher than hurdle rate then the project can be accepted and vice versa.

Dis-advantages of using IRR

1. IRR ignores the Economies of scale where it does not deal with the dollar value of cashflows rather looks at the return in comparison to the investment. That is the reason why NPV scores over IRR where NPV deals with the dollar value of cashflows

2. IRR also works on the assumption of re-investing at the same rate where it is not always possible to reinvest the cashflows at the same rate (IRR), In case of a project with low low IRR, it assumes reinvestment at a low rate, on the contrary, if the other project has a very high IRR, it assumes reinvestment at the high rate of return. This version does not hold good

3. IRR does not consider the possibility of Dependant or contingent projects

NPV computation

Year	0	1	2	3	4	5	6	7	8	9	10
Capital investment (in Mn)	-37
Revenue		26.00	26.00	26.00	26.00	26.00	26.00	26.00	26.00	26.00	26.00
Cost		10.00	11.70	13.69	16.02	18.74	21.92	25.65	30.01	35.11	41.08
Operating cashflows (in Mn) (Revenue - Cost)		16.00	14.30	12.31	9.98	7.26	4.08	0.35	(4.01)	(9.11)	(15.08)
Net cashflows	(37.00)	16.00	14.30	12.31	9.98	7.26	4.08	0.35	(4.01)	(9.11)	(15.08)
PV factor @ 5% ---> Formula-->1/(1+cost of capital)^nth year	1.0000	0.9524	0.9070	0.8638	0.8227	0.7835	0.7462	0.7107	0.6768	0.6446	0.6139
PV of cashflows (Net cashflows) x PV factor	(37.00)	15.24	12.97	10.63	8.21	5.69	3.04	0.25	(2.72)	(5.88)	(9.26)
NPV - sum of PV of cashflows (in $)	1.18

Since the projects carries a positive NPV, project can be taken up.