Question

Corporate Financial Management:Capital Budgeting

14. a.Jose and Louis run a clothing manufacturing company and are considering expanding their business to include manufacturing and printing customised football jerseys. Neither knows much about football or finance. Knowing that you have recently completed a finance class, they ask you for advice on whether or not to undertake this project. They have provided you with the following information.

They project unit sales of the football jerseys will be 5,000 in the first year, with growth of sales of 15 per cent each year for the next five years. Production of the jerseys will require €28,000 in net working capital to start. Total fixed costs are €75,000 per year while variable costs are €20 per jersey. Each jersey will have a selling price of €45. An initial up front cost of €60,000 will be required to purchase a new machine to manufacture and print the jerseys. The equipment is to be depreciated using the reducing balance method of depreciation and it not expected to have any salvage value. The rate of depreciation to be used is 20%. The tax rate the company faces is 28% and in order to invest in the project, Jose and Louis require a rate of return of 25%.

Write a report to Jose and Louis advising them whether or not you would recommend investing in this project. Show three investment evaluation techniques (one of which must be NPV analysis) to support your recommendation. If the required rate of return fell to 12%, would your recommendation change? Explain why or why not.(100 %)

Answer 1

1)	NPV:	0	1	2	3	4	5	6
	Sales in units		5000	5750	6613	7604	8745	10057
	Sales revenue		€      2,25,000	€    2,58,750	€     2,97,585	€      3,42,180	€    3,93,525	€   4,52,565
	Variable cost of production		€      1,00,000	€    1,15,000	€     1,32,260	€      1,52,080	€    1,74,900	€   2,01,140
	Fixed costs		€          75,000	€        75,000	€         75,000	€          75,000	€        75,000	€       75,000
	Depreciation		€          12,000	€          9,000	€           6,750	€            5,063	€          3,797	€         2,848	€         39,457
	Loss on scrapping of machine (book value)							€       20,543
	Incremental NOI		€          38,000	€        59,750	€         83,575	€      1,10,038	€    1,39,828	€   1,53,034
	Tax at 28%		€          10,640	€        16,730	€         23,401	€          30,811	€        39,152	€       42,850
	Incremental NOPAT		€          27,360	€        43,020	€         60,174	€          79,227	€    1,00,676	€   1,10,185
	Add: Depreciation		€          12,000	€          9,000	€           6,750	€            5,063	€          3,797	€       23,391
	Incremental OCF		€          39,360	€        52,020	€         66,924	€          84,290	€    1,04,473	€   1,54,118
	Capital expenditure	€           60,000
	Change in NWC	€           28,000						€     -28,000
	Incremental net cash flows	€         -88,000	€          39,360	€        52,020	€         66,924	€          84,290	€    1,04,473	€   1,82,118
	PVIF at 25% [PVIF = 1/1.25^n]	1	0.80000	0.64000	0.51200	0.40960	0.32768	0.26214
	PV at 25%	$         -88,000	$          31,488	$        33,293	$         34,265	$          34,525	$        34,234	$       47,741	$     1,27,546
	NPV	$       1,27,546
2)	PROFITABILITY INDEX:
	PI = PV of cash inflows/Initial investment = 215546/88000 =	2.45		`
3)	IRR:
	IRR is that discount rate for which NPV = 0. It has to be found out by trying different discount rates till 0 NOV is achieved.								NPV
	PVIF at 64%	1	0.60976	0.37180	0.22671	0.13824	0.08429	0.05140
	PV at 64%	€         -88,000	€          24,000	€        19,341	€         15,172	€          11,652	€          8,806	€         9,360	€               332
	PVIF at 65%	1	0.60606	0.36731	0.22261	0.13492	0.08177	0.04956
	PV at 65%	€         -88,000	€          23,855	€        19,107	€         14,898	€          11,372	€          8,542	€         9,025	€         -1,200
	IRR = 64%+1%*332/(332+1200) =	64.22%
	DECISION:
	The project is recommended for implementation as NPV is positive, IRR is greater than MARR and PI is greater than 1.
	If MARR is 12%, the NPV and PI will increase, and the IRR will continue to be greater than MARR. Still the decision is the same.