Question
A Company operating in Confectionary manufacturing has developed a new chocolate line that can be sold for $10 per box and that is expected to
A Company operating in Confectionary manufacturing has developed a new chocolate line that can be sold for $10 per box and that is expected to have continuing popularity for many years. For this particular product the CFO has proposed that investment should be evaluated over a five-year time-horizon, even though sales would continue after the fifth year, on the grounds that cash flows after five years are too uncertain to be included in the evaluation. The variable and fixed costs (both are presented in current price terms/real/) will depend on sales volume, as follows.
Sales Volume (boxes) | less than 1 million | 1-1.9 million | 2-2.9 million | 3-3,9 million |
Variable cost ($ per box) | 2.5 | 2.8 | 2,9 | 3,1 |
Fixed costs ($) | 1 million | 1,6 million | 2,5 million | 3,6 million |
The Company has hired a famous Marketing company to evaluate the market demand for the product and make suggestion on the pricing for the product. This has caused an unrecoverable cost of $260.000 for the marketing services. Forecast sales volumes are as follows.
Year | 1 | 2 | 3 | 4 | 5 |
Demand (boxes) | 0.8 million | 1,6 million | 2,7 million | 2,8 million | 3,4 million |
The production equipment for the new confectionery line would cost $2.7 million and an additional initial investment of $150,000 would be needed for working capital and, thereafter, working capital is forecasted to be 10% of sales in the following year. Also, there is an annual cost of $50.000 (in current prices/real/) to keep the equipment in working condition. The salvage value of machinery at the end of the five-year project is $200,000 and a company expects to resell the old equipment for 500,000 (market price) at the end of the project. Straight method of depreciation is used as tax-allowable method and it allows annual 20% depreciation on the cost of equipment. Profit tax of 18% per year is applicable. The average general level of inflation is expected to be 3.5% per year and selling price, variable costs, fixed costs and maintenance would all experience inflation of this level. The Company uses a nominal after-tax cost of capital of 12% to appraise new investment projects.
Requirements:
1.Please calculate the nominal cash flows of the project for the five-year time-horizon;
2. Calculate the NPV, IRR, Payback period, discounted payback and Profitability index for the project (Interpret the results);
3, Advise on the acceptability of the proposed investment in product line
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