B. Capital budgeting

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It has been three months since you graduated with a BCom and joined the graduate programme at Mystic Products. You have already made a name for yourself as being reliable and diligent. Your next assignment is to evaluate an independent project. Given your status as "high potential" but considering your lack of experience, your line manager has asked you not only to provide a recommendation whether to accept or reject the project but also to respond to a number of questions, so he can judge your understanding of making capital budgeting decisions.

A consulting firm hired by Mystic Products for a cost of $25,000 identified a market opportunity to introduce a new product to the super city of Auckland. The initial outlay for equipment is estimated to be $650,000 and it can be depreciated over five (5) years, when the project will end due to diminishing yields. The initial working capital requirement to get the production started is estimated to be 10% of the expected sales in the first year of $1,000,000. All working capital is liquidated at the termination of the project. The average operating cash inflow forecasted for the next 5 years is $230,000. The required rate of return for the project is 13%.

Required

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You can download the formula sheet here if you haven't already

a. Calculate the initial investment. (3 marks)

b. What are the operating cash flows over the life of the proposed project? (1 mark)

c. What is the terminal cash flow? (3 marks)

d. What is the net present value? (4 marks)

e. What is the project's payback period? (2 marks)

f. Should the project be accepted or rejected? Please explain why or why not. Mystic's maximum payback period for similar short-lived projects is around 2.5 years. (4 marks)