Question

The directors of Hanren Plc, a listed company, have decided to update the processing equipment at their division based in South Wales. The project named ‘Invector’ will need new equipment costing £10.5 million.

The equipment would last for five years, at the end of which it would be replaced. The scrap value of the equipment is expected to be 4% of the initial cost.

Capital allowances would be available on the cost of the equipment on a 20% reducing balance basis, with a balancing allowance or charge claimed in the final year of operation.

The equipment will produce 15,000 units per year throughout its useful life.

Relevant financial information in current price terms is as follows:

Selling price £630 per unit with inflation 3·5% per year Variable cost £380 per unit with inflation 2·5% per year

Each model will take a share of existing overheads to the sum of £625,000 per annum and incremental overheads of £320,000 both quoted in current prices. Inflation of 4·0% per year applies to overheads.

The equipment will also require the use of warehouse space, which is currently generating rental income of £125,000 per annum. This income, which is fixed for five years, will be lost if the project goes ahead.

There will be working capital requirements of £600,000 at the outset, and thereafter working capital should be maintained at 7% of the sales revenue of the forthcoming year. Working capital will be repaid in full at the end of the project.

Hanren Plc pays tax on profits at the rate of 30% per year, one year in arrears.

The company has a nominal (money terms) after-tax cost of capital of 12% per year.

Hanren Plc has £15 million to invest in suitable capital projects in the coming year. A number of options are being considered alongside the ‘Invector’ project. The board are unlikely to go ahead with all of the projects.

A calculation of the net present value (NPV) of the planned purchase of equipment using a nominal (money terms) approach. A detailed analysis showing how the NPV has been calculated should be included as an appendix to the report, together with any assumptions and related calculations.

B. Advice on the viability of the proposed investment to include the following: i. a recommendation whether to undertake the project; ii. justifications for your recommendation, including the reasons for using the NPV method; and iii. a brief summary of other information that the company should consider before making a final investment decision.

Answer 1

A) Calculation on Net Present Value of planned purchase of equipment using nominal approach:

Net present value is present value derived by calculation present value of cash inflows of project and thereby reducing initial cash outlays of project.

a)

1) Initial Investment in the project:

Invector project will need new equipment which is costing at pound 10.5 million.

Scrap value= 4% of initial cost

= 4% of pound 10.5 million

= pound 0.42 million.

Life of the equipment= 5 years.

Now we need to calculate depreciation.

Depreciation = Initial cost - scrap value

life of equipment

=  pound 10.5 million - pound 0.42 million

5 years

= pound 2.016 million per year.

2) Capital allowance = 20% on cost of equipment on reducing balance method.

capital allowance= pound 10.5 million * 20% = pound 2.1 million.

3) Production of Hanren Plc. = 15,000 units per year.

Selling price per unit = pound 630 with inflation 3.5%

Variable cost per unit = pound 380 with inflation 2.5%

Existing overheads = Pound 6,25,000 per annum with inflation of 4%

Incremental overheads = Pound 3,20,000 with inflation of 4%

4) Due to purchase of new equipment, firm will lose rental income of pound 1,25,000 per year which is fixed for 5 years.

If firm purchases new equipment, the space earlier used for other purposes and given on rent will now be used for this new equipment and due to which firm will lose it's rental income and which will become it's expenditure.

5) Working capital requirement at the beginning = pound 6,00,000.

For forthcoming years working capital requirement will be 7% of sale revenue.

Working capital requirement to be repaid at the end of the project = Full value

6) Tax rate = 30%

cost of capital =12%

Hanren plc. has pound 15 million to invest in suitable projects.

Inflation effects for 5 years:

Revenue	Inflation @ 3.5%	Variable Cost	Inflation @ 2.5%
Current year= 15000 units * 630=9.45 million.	-	Current year= 15,000 units * 380=5.7 million	-
Year 1	9.45 million+3.5%of 9.45 million= 9.78075 million	Year 1	5.7 million+2.5% of 5.7 million= 5.8425 million
Year 2	9.78075+3.5%=10.12307625 million	Year 2	5.8425+2.5%=5.98856 million
Year 3	10.12307625 + 3.5%=10.47738 million	Year 3	5.98856+2.5%=6.13828 million
Year 4	10.47738+3.5%= 10.84409 million	Year 4	6.13826+2.5%= 6.29173 million
Year 5	10.84409+3.5%= 11.22363 million	Year 5	6.29173+2.5%= 6.44903 million.

Overheads inflation effect:

Existing overheads	Inflation @ 4%	Incremental overheads	Inflation @ 4%
Year 1=625000	625000+4%=650000	Year 1=320000	320000+4%=332800
Year 2 = 650000	650000+4%=676000	Year 2=332800	332800+4%=346112
Year 3=676000	676000+4%= 703040	Year 3=346112	346112+4%=359956
Year 4=703040	703040+4%= 731162	Year 4=359956	359956+4%=374355
Year 5=731162	731162+4%=760408	Year 5=374355	374355+4%=389329

Working capital should be maintained at 7% of sales revenue of forthcoming year.

Particulars	Working capital requirement
Year 1	Year 2 sales 10.12307625 million * 7%= pound 0.70862
Year 2	Year 3 sales 10.47738 million * 7%= pound 0.73342
Year 3	Year 4 sales 10.84409 million *7%= pound 0.75909
Year 4	Year 5 sales 11.22363 million *7%= pound 0.78565
Year 5	Year 6 sales as 11.22363+3.5%=11.61646 *7% = pound 0.8131522 million.

Calculation of initial investment:

Initial cost of capital	Pound 10.5 million
Working capital requirement at the beginning	Pound 6,00,000
Total cash outflows	Pound 11.1 million

b)

Calculation of cash inflows of the project: Amount in pounds

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Revenue	9780750	10123076	10477380	10844090	11223630
Less: Variable cost	(5842500)	(5988560)	(6138280)	(6291730)	(6449030)
Less: Existing Overheads	(650000)	(676000)	(703040)	(731162)	(760408)
Less: Incremental Overheads	(332800)	(346112)	(359956)	(374435)	(389329)
Less: Rental income lost	(125000)	(125000)	(125000)	(125000)	(125000)
Less: Depreciation	(2016000)	(2016000)	(2016000)	(2016000)	(2016000)
Less: capital allowance					(2100000)
Sub total	814450	971404	1135104	1305763	(616137)
Less: tax @ 30%	(244335)	(291421)	(340531)	(391729)	184841
	570115	679983	794573	914034	(431296)
Add back: Depreciation	2016000	2016000	2016000	2016000	2016000
Cash inflows	2586115	2695983	2810573	2930034	1584704

c) Calculation of Cash inflows at the end of year 5:

Scrap value of equipment	0.42 million
Repayment of working capital	0.8131522 million
Total cash inflow at the end	1.2331522 million

Calculation of NPV:

Year	Particulars	Discounting factor @ 12%	Discounted cashflows
0	Initial investment =pound 11100000	1	(11100000)
1	Cash inflow =2586115	0.8929	2309142
2	Cash inflow=2695983	0.7972	2149238
3	Cash inflow= 2810573	0.7118	2000566
4	Cash inflow=2930034	0.6355	1862036
5	Cash inflow= 1584704	0.5674	899161
5	Cash inflow at the end=1233152	0.5674	699690

Net present value = pound 1180166.

B)

i) Henren plc should undertake the project as net present value of the project is positive.

ii) Company's Cash inflows are more than cash outflows.i.e. company is not in loss and therefore by accepting this project it is viable for the company to recommend the project as it is beneficial for the company. Net present value is well within company's budget.

iii) Other information that the company should consider before making a final investment decision is

• Company should include all the risk and rewards before making any decision.
• Company should overview it's financial policy and should discuss the matters with other stakeholders.
• Company should lookafter whether it is going through any financial crisis if not it can accept the project.
• It should consider whether while accepting the project is it beneficial for the company to do so.
• Company should all the facts and should make final decision.