Britannia Company is considering opening a new production line in South England on 5,000 acres of land purchased 10 years ago for $4 million. Opening the new production line will cost the company $100 million to purchase the necessary equipments, which will be depreciated to zero based on the straight- line method for ten years. The company estimates that the equipment can be sold for 10% of its initial purchase price in ten years.

The contract, that the company has, calls for the delivery of 500,000 units per year at a price of $86 per unit. If the new line is opened, the increase in the production is estimated to be 620,000 units, 680,000 units, 730,000 units, 590,000 units, 520,000 units, 580,000 units, 630,000 units, 580,000 units, 530,000 units and 590,000 units respectively, over the next ten years. After satisfying the contract, the excess production will be sold in the spot market at an average of $77 per unit. Variable costs amount to $31 per unit, and cash fixed costs are $4,100,000 per year.

Before implementing the project, the company will need to reserve a net working capital (NWC) that is 5% of estimated sales for the coming year. Each year the NWC will need to be maintained and to be matched with the estimated sales for the next year. Assume the company will fully retrieve the NWC at the end of the project.

Britannia faces a tax rate of 25% and has a required rate return of 15% on the new project. Assume that a loss in any year will result in a tax credit. You have been approached by the president of the company with a request to analyze the project. Should Britannia take the contract and open the production line?

Required 1: Calculate the payback period, profitability index, net present value, and internal rate of return for the new project to meet the new contract. What do these criteria say about the decision? Begin the report by briefly explaining the capital budgeting methods. Explain why net present value and internal rate of return criteria are considered superior to the accounting rate of return and payback period used by some firms.

Required 2: Some estimates are subjective and may be prone to judgment error or uncertainty. For this reason, please conduct a sensitivity analysis of NPV to the required rate of return falling between the ranges of 16% to 24% p.a. (with increments of 1%) for the contract. Discuss the implications.