Question

Sanofi Health Equipment recently just obtained a sales contract on producing Personal Protection Equipment (PPE) for the medical staff in America. The contract will last for 4 years that required the investment of machinery and production system.

The management believes that the sales for the company will grow at 20 percent every year for 4 years until the discovery of a vaccine for COVId-19. The company will set-up three production lines that cost USD1.5 million each.

To boost up productivity, the management needs to modify and renovate the company's existing premises that cost USD 500,000. The new production lines would require to increase investments in an inventory of USD1,000,000, an account receivable of USD500,000, and an account payable of USD1,200,000.

The management forecasts the sales for the company to increase by USD2,800,000 for the first year and a growth of 20 percent along with the contract. The cost of goods sold will be 50 percent of the sales growth. Depreciation adopted for this investment is based on the straight-line method.

At the end of the contract, the management will be able to sell all the production lines for USD250,000. The corporate tax rate for the company is 35 percent and the cost of financing for this investment is 14 percent per annum.

1. Identify the initial capital needed for the setting up of three production lines.

2. Forecast the changes of net cash flow from year 1 to year 4.  

3. Identify the terminal cash flow for Pelangi Health at year 4.   

4. Advise the management whether they should invest in the production line. Justify your answers.   

Answer 1

All amounts are in USD

1. Initial capital required :

Production line costs = 1.5 million x 3 = 4.5 million

Renovation costs = 500,000

Increase in working capital = 300,000

[Increase in (inventory + accounts receivable - accounts payable)] (1,000,000 + 500,000 - 1,200,000)

Adding these three costs will give us the initial capital required = 5,300,000

2. Changes in net cash flow from year 1 to year 4

A. Sales for 1st year = 2,800,000

B. Cost of goods sold for year 1 = 1,400,000 (50%)

C. Profit (A-B) = 1,400,000

D. Tax @35% = 490,000 (C x 35%)

E. Profit after tax (C-D) = 910,000

F. Tax savings on Depreciation = 153,125 (312,500x35%) + (125,000 x 35%)

G. Cash inflow for 1st year (E+F) = 1,063,125

Cash flow for 2nd year = 910,000 x 120% + 153,125 = 1,245,125

Cashflow for 3rd year = 910,000 x 120% x 120% + 153,125 = 1,463,525

Cashflow for 4ty year = 910,000 x 120% x 120% x 120% + 153,125 = 1,725,605

This will increase at 20% for each year in future

Year	Cashflow (20% growth)	Present value factor @14%	Amount
1	1,063,125	0.8772	932,573.25
2	1,245,125	0.7695	958,123.6875
3	1,463,525	0.6750	987,879.375
4	1,725,605	0.5921	1,021,730.7205
4	750,000 (250,000 x 3)	0.5921	444,075
4	300,000	0.5921	177,630
	Total inflow		4,522,011.983

The above table is forecast of Cashflows from year 1 to year 4. The cashflow from 2nd year is 20% greater than 1st year and so on. The last cashflow of 250,000 is residual value for each asset. The 300,000 is recoupment of investment in working capital that was invested at start. No tax will be there on residual value, as the carrying amount equals to residual value.

Depreciation = (1,500,000 - 250,000)/4 = 312,500

Depreciation on renovation = 500,000/4 = 125,000

3. Terminal cashflow means cashflow at the termination of the capital investment on a project.

Terminal cashflow = 177,630 + 444,075 = 621,705

4. Net present value = Total cash inflows - Net cash outflows

= 4,522,011.983 - 5,300,000

= -777,988.017

Since NPV is negative, the company shouldn't invest in project