The directors of AAP company limited has decided to limit investment funds to $10 million for the next year and is preparing its capital budget. The company is considering five projects, as follows:
Initial investment Net present value
Project A $2,500,000 $1,000,000
Project B $2,200,000 $1,550,000
Project C $2,600,000 $1,350,000
Project D $1,900,000 $1,500,000
Project E $5,000,000 To be calculated
All five projects have a project life of four years. Projects A, B, C and D are divisible, and Projects B and D are mutually exclusive. All net present values are in nominal, after-tax terms.
Project E
This is a strategically important project which the Board of AAP Co have decided must be undertaken in order for the company to remain competitive, regardless of its financial acceptability. Information relating to the future cash flows of this project is as follows:
Year 1 2 3 4
Sales volume (units) 12,000 13,000 10,000 10,000
Selling price ($/unit) 450 475 500 570
Variable cost ($/unit) 260 280 295 320
Fixed costs ($000) 750 750 750 750
These forecasts are before taking account of selling price inflation of 5•0% per year, variable cost inflation of 6•0% per year and fixed cost inflation of 3•5% per year. The fixed costs are incremental fixed costs which are associated with Project E. At the end of four years, machinery from the project will be sold for scrap with a value of $400,000.
AAP Co has a nominal after-tax cost of capital of 13% per year.
Required:
a) Evaluate the financial acceptability of project E using: i. a nominal terms net present value approach ii. an internal rate of returns approach
b) Calculate the maximum net present value which can be obtained from investing the fund of $10 million, assuming here that the nominal after-tax NPV of Project E is zero.