Assume that you have been appointed finance director of Breckall pic. The company is considering investing in the production of an electronic security device, with an expected market life of five years.

The previous finance director has undertaken an analysis of the proposed project; the main features of his analysis are shown below. He has recommended that the project should not be undertaken because the estimated annual accounting rate of return is only 12.3%.

All of the above cash flow and profit estimates have been prepared in terms of present day costs and prices, since the previous finance director assumed that the sales price could be increased to compensate for any increase in costs.
You have available the following additional information:

(a) Selling prices, working capital requirements and overhead expenses are expected to increase by 5%
per year.

(b) Material costs and labour costs are expected to increase by 10% per year.

(c) Capital allowances (tax depreciation) are allowable for taxation purposes against profits at 25% per year on a reducing balance basis.

(d) Taxation on profits is at a rate of 35%, payable one year in arrears.

(e) The fixed assets have no expected salvage value at the end of five years.

(f) The company's real after-tax weighted average cost of capitalts estimated to be 8% per year, and nominal after-tax weighted average cost of capital 15% per year .
Assume that all receipts and payments arise at the end of the year to which they relate. except those in year 0, which occur immediately Required

(a) Estimate the net present value of the proposed project. State clearly any assumptions that you make .
(13 marks)

(b) Calculate by how much the discount rate would have to change to result in a net present value of approxrmately zero. (4 marks)

(c) Describe how sensilivtty analysis might be used to assist in assessmg this proJecl What are the weaknesses of sensitivity analysts tn caprtal rnvestment apprarsat? Briefly outline alternative techniques of incorporating risk into capital investment appraisal.

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Proposed electronic security device project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 (000) (000) (000) (000) (000) (000) Investment in depreciable fixed assets 4500 Cumulative investment in working capital 300 400 500 600 700 700 Sales 3500 4900 5320 5740 5320 Materials 535 750 900 1050 900 Labour 1070 1500 1800 2100 1800 Overhead 50 100 100 100 100 Interest 576 576 576 576 576 Depreciation 900 900 900 900 900 3131 3826 4276 4726 4276 Taxable profit 369 1074 1044 1014 1044 Taxation 129 376 365 355 365 Profit after tax 240 698 679 659 679 Total initial investment is 4800000 Average annual after tax profit is 591000