Question -
Multimakks Limited Steel Division is considering a proposal to purchase a new machine to manufacture a new product for a potential three-year contract. The new machine will cost $12.8 million. The machine has an estimated life of four years for accounting and taxation purposes. The contract will not continue beyond four years. An investment allowance of twenty percent on the outlay is available. Extra marketing and administration cash outflows of $251,000 per year will be incurred by the Steel Division for the project. The projections provided here are based on the feasibility study undertaken by HXBC bank. Cash operating expenses are estimated to be 68 percent of sales revenue (excludes marketing and administration, and head office items). Except for initial outlays, assume cash flows occur at the end of each year (unless otherwise stated).
Additional Information
a. The sales price per unit of product is $158.
b. Estimated Sales volume of the product is 152,000units for Year 1. In years 2, 3 and 4 the total sales revenue will increase in line with economic growth.
c. The nominal economic growth rate is projected to be 4% per year.
d. The project will be in operation for 4 years; then it will terminate. In the final year of the project the machinery will be sold for 7.5% of its initial, total value.
e. Last year, Multimakks Ltd. paid HZPC Bank $500, 000 for a feasibility study that confirmed the manufacturing expansion was economically viable.
f. The machinery is considered depreciable for tax purposes and will be depreciated using a diminishing value method (This is equal to twice the annual straight-line rate).
g. The project will require a provision of $370,000 in working capital.
h. There will be additional Sales and Marketing expenses if the project goes ahead. This has been estimated to be $251,000 for Year 1. After this, the additional annual Sales and Marketing expenses will increase with inflation.
i. Head Office expenses will not increase. However, a fixed allocation of $230,000 per year will be charged to this project.
j. Cash operating expenseswill be 68% of Sales Revenue.
k. The investment project is considered not to be in line with the company's core business and is of a higher risk.
- HZBC calculated the real required rate of return on a higher risk project such as this to be 10.65% (after tax).
l. Inflation is projected to be 2.0% per year for the period of the investment.
m. The company tax rate is 27% and tax is paid in the year after the income is earned.
n. Assume all cash flows are in Nominal values, unless otherwise stated.
(1) Calculate the NPV. Is the project acceptable? Why or why not?
(2) Conduct a sensitivity analysis showing how sensitive the project is to sales revenue and to the cost of capital. Explain.
(3) From a theoretical perspective, what additional insight can Scenario analysis give, that sensitivity analysis cannot? (You may use numbers to illustrate your answer but you do not have to).
(4) Explain how risk has been priced into this project and explain the extent to which management may be confident the return on investment is in accordance to its risk.