Question

Question 3

a) Enlightened Ltd is investigating the introduction of a new advanced solar light. Forecast revenue from the new light is $1,250,000 per year and variable costs $450, 000 per year. The revenue and variable costs are expected to stay constant for the four years. The new light will require a new production line that will have an initial cost of $2,000,000. For tax purposes you can depreciate the full cost down to zero over the four year life of the project. At the end of four years you expect to be able to sell the production machinery for $350,000. Selling the new fixtures will require additional working capital of $25,000 starting immediately. You expect to recover the working capital investment at the end of the four year project. You have already spent $50,000 in research and development costs to invent the new light. Assume the tax rate is 30% and the required return is 10% APR (compounded annually).

i) What is the annual depreciation of the new production line?

ii) What is the annual Operating Cash Flow for the project?

iii) What are the Project Cash Flows for the project?

iv) What is the NPV for the project? What information does the NPV provide?

v) What is the payback period for the project? What information does the payback period provide?

vi) Should Enlightened Ltd proceed with the new solar light project? Justify your answer.

b) What is sensitivity analysis and how is it used in project evaluation?

Answer 1

i)	Annual depreciation = 2000000/4 =	$      5,00,000
ii)		0	1	2	3	4
	Revenue		$    12,50,000	$ 12,50,000	$ 12,50,000	$ 12,50,000
	Variable costs		$      4,50,000	$    4,50,000	$    4,50,000	$    4,50,000
	Depreciation		$      5,00,000	$    5,00,000	$    5,00,000	$    5,00,000
	Incremental NOI		$      3,00,000	$    3,00,000	$    3,00,000	$    3,00,000
	Tax at 30%		$          90,000	$        90,000	$        90,000	$        90,000
	NOPAT		$      2,10,000	$    2,10,000	$    2,10,000	$    2,10,000
	Add: Depreciation		$      5,00,000	$    5,00,000	$    5,00,000	$    5,00,000
	Operating cash flow		$      7,10,000	$    7,10,000	$    7,10,000	$    7,10,000
iii)	Capital expenditure	$    20,00,000
	Change in NWC	$          25,000				$      -25,000
	Salvage value of the equipment					$    3,50,000
	Tax at 30% on salvage value					$    1,05,000
	Project cash flows	$ -20,25,000	$      7,10,000	$    7,10,000	$    7,10,000	$    9,80,000
iv)	PVIF at 10%	1	0.90909	0.82645	0.75131	0.68301
	PV at 10%	$ -20,25,000	$      6,45,455	$    5,86,777	$    5,33,434	$    6,69,353
	NPV	$      4,10,018
	The NPV gives the dollar addition to shareholders' wealth in PV terms if, the project is undertaken.
v)	Cumulative project cash flows	$ -20,25,000	$ -13,15,000	$   -6,05,000	$    1,05,000	$ 10,85,000
	Payback period = 2+605000/710000 =	2.85	Years
vi)	Yes, Engineering Ltd should proceed with the new solar light project.
	This is because the NPV of the project is positive. All projects with positive NPV
	will add to the shareholders' wealth.
b)	Sensitivity analysis is the process of revising the base case NPV [or IRR etc}
	by varying the input values like quantity sold, price, cost etc. It highlights
	the riskiness of a project if there is + or - variation in the values of the inputs.