Question

Trump De Drum Ltd (TDT) is a company in aquacultural industry specialised in farming of aquatic organisms. DT 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 2021.

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

1/7/2021

1/7/2022

1/7/2023

1/7/2024

1/7/2025

Ending

30/6/2022

30/6/2023

30/6/2024

30/6/2025

30/6/2026

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 tons 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.

Your tasks:

Based on the information in the case study, P. De Potato has asked you to write a report to TDT’s management advising them as to the best course of action regarding this project. Your report should address the following specific questions asked by management:
Do any 4 questions will be fine*******
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Calculate the Net present value (NPV) of the project, assuming that the initial investment could be sold at the end of the five years for $1 million. Briefly comment on your results and make appropriate remarks on the assumptions made for these calculations if necessary.
Estimate the Internal rate of return (IRR) of the project. Briefly comment on your results
Using sensitivity analysis, recalculate NPV using the scenario of
A decrease in project sales by 10% annually.
An increase of the sale price by 5% annually
An increase of material costs change from 3.5% to 8% Briefly comment on your results.
In view of your answer to Point 4 to point 7 above, advise TDT’s management as to whether they should go ahead with the investment project. In your recommendations, you may wish to suggest possible refinements in the method used for evaluating this project.

Answer 1

Input/Formula Sheet:

Output Sheet:

2. Internal rate of return (IRR) of the project: 14.78%

3. Sensitivity analysis, recalculate NPV using the scenario of

A decrease in project sales by 10% annually: NPV = 20754

Updated Production

Financial Year		2021-22	2022-23	2023-24	2024-25	2024-25
Production Quantity (In Tons)		108	126	153	166.5	166.5

An increase of the sale price by 5% annually: NPV = 497948

Updated Selling Price

Financial Year		2021-22	2022-23	2023-24	2024-25	2024-25
Selling Price Per Ton		9450	9607.5	9712.5	9765	9817.5

An increase of material costs changes from 3.5% to 8% Briefly comment on your results. NPV: 226223.07

Updated Material Cost:

Financial Year		2021-22	2022-23	2023-24	2024-25	2024-25
Material Cost (Per Ton)		2000.00	2160.00	2332.80	2519.42	2720.98

4. Yes, they Should Accept The project. However please take Production in consideration. Because it is most Sensitive.

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