CAPITAL BUDGETING Replacement

BC Textile Corporation is considering the issue of a new product to be added to its product mix, a new designed textile. They hired you, a recent business graduate from UCW, for conducting the analysis. The production line would be set up in an unused space at the companys main plant. The plant space could be leased out to another firm for $25,000 per year. They have to buy new machinery to fit the production and will disposal the old machine. The approximate cost of the new machine would be $200,000, with another $10,000 in shipping and handling charges. It would also cost an additional $30,000 to install the equipment. The new machinery has an economic life of 5 years and would fall under Class 8 with a CCA rate of 20%. It is expected to have a salvage value of $25,000 after 5 years of use.

The old machine was purchased 2 years ago before the project with $150,000, plus $30,000 installation fees. It has an economic life of 5 years and would fall under Class 5 with a CCA rate of 15%.

Currently the old machine is producing sales of 1,500 units per year in its economic life and the sales are expected to grow 5% per year. The variable cost per unit that the old machine produced is estimated as $75 per unit in the first year. Each unit can be sold for $150 in the first year. The net operating working capital would have to increase by an amount equal to 10% of sales revenues. The company has signed a contract to sell the old machine with $80,000 to accommodate the new machine.

The new product line would generate sales of 2,000 units per year for 5 years and they are expected to grow 8% per year. The variable cost per unit is estimated in $80 per unit in the first year. Each unit can be sold for $200 in the first year.

The fixed costs are estimated to be $100,000 per year and would increase with inflation. To handle the new product line, the firms net operating working capital would have to increase by an amount equal to 15% of sales revenues. The firm tax rate is 35%, and its overall weighted average cost of capital (WACC) is 10%. The project is considered by the financial department to be as risky as the company. However, the sales division addressed their concern that the new project will affect the existing another textile by $200,000 per year, The financial division has estimated that sales price and cost are both expected to increase by 2.5% per year due to inflation.

Requirements

1. Using an Excel spreadsheet or write in Word/PDF file (3 marks):

• Find the NPV, and IRR of the project by determine the cash flows. The calculation must be formula driven. Show all the steps in the submission

2. Sensitivity analysis (2 marks)

1. Perform sensitivity analysis on the unit sales, variable costs and the cost of capital for the project. Assume that each of these variables can vary from its base-case value by 10% and 20%. Summarize the results in a table (NPVs for each sensitivity analysis).

3. Assume that you are confident of your estimates of all variables that affect the projects cash flows except unit sales and sales price. If product acceptance is poor, unit sales will be only 900 units a year and the unit price will be only $160; a strong demand will produce sales of 1,800 units and a unit price of $240. The marketing department told you that there is a 25% chance of poor acceptance and 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case). (2 marks)

1. What is the worst case NPV and the best case NPV?
2. What is the expected NPV for this project considering all possibilities?

4. Recommendation (3 marks)

Use the results you obtained in the NPV, IRR, breakeven, sensitivity and scenario analysis above to write a one page report on your findings and recommend whether or not the company should proceed with the project. ( Hint: incl NPV, IRR rationales, critics, discount rate impacts, and the analysis to the cash flows and