KanD Spares Ltd produces and sells engine spares for major car brands. Currently, it is considering producing and selling prime Volvo engine component to its five wholesale customers from its three stores. The Volvo engine component will sell for £750 per set and have a variable cost of production of £340 per set. The average cost of delivering Volvo component to any of customer from any of its store is £120 per component. The cost of transporting components from the production unit to the stores is included in the production cost. The company has spent £150,000 for a marketing study that determined the company will sell 60,000 components per year for the coming seven years.

The marketing study also determined that the company will lose sales to the tune of an annual average of 13,000 components of its Toyota engine component which sells at £ 1,400 and have total variable costs of £900 per component.

The company will also increase sales of its Scania engine component by an annual average of 12,000 components. The Scania engine component sells for £400 and has total variable cost of £200 per set. The fixed costs each year will be £7,500,000. The Company has also spent £1,000,000 on research and development for the Volvo engine component.

The plant and equipment required for production will cost £18,200,000 and will be depreciated on a 20 percent reducing balance basis. At the end of the seven years, the the plant and equipment will be sold at price equal to its book value.

The production of Volvo engine components will also require an increase in net working capital of £950,000 at the onset of the project increasing at an annual rate of 5% based on previous year’s cumulative net working capital level for years 1 to 5; all investment in working capital will be recovered at the end of the project. The corporation tax rate is 30 percent payable one year in arrear, and the cost of capital is 14 percent.

REQUIRED:

1. Prepare the statement of tax shield on capital allowance (or economic depreciation) for the project and calculate its value at time zero. Hint: The statement should show annual capital allowances and corresponding tax shield in separate rows.
2. Prepare the estimate of “Statement of Comprehensive Income” showing all income and all expense items up to the tax liability
3. Prepare the statement of an estimate of incremental cash flows resulting from implementing the project and show change in net cash flows.
4. Use the net cash flows estimated in part (c ) above and:
   • Calculate the NPV and IRR of the investment and recommend whether Volvo engine components should be produced and sold or not.
   • List at least five assumptions made in your estimate of NPV

5. Use data table to generate NPV associated with possible fluctuations in cost of capital if the cost of capital cannot fall below 1% and cannot exceed 25%. Plot the resulting NPV profile with cost of capital in X-axis.
6. Consider the possible values of some project variables given in table below and choose five out of possible scenarios such that one of the chosen scenarios reflect worst cases and name it “WORST”, one reflects best cases (name it “BEST” and the remaining three scenarios (name them “COMBINED ONE”, “COMBINED TWO” and “COMBINED THREE”) reflect combinations of pessimistic and most likely cases of these variables and then use Scenario manager to show NPV for each scenario chosen. Note: Best or worst scenarios are defined on the basis of the best NPV likely to be generated. What do the results imply to management in terms of risk of this investment project? (Hint: Make sure that the determined scenarios show each variable at least once)

7. Management is considering delivery of Volvo engine components to its five (5) customers from its three stores. The cost of delivery to each customer from each store and the demand of each customer for each year are given in table below.

Use Solver tool to calculate number of components to be delivered to each customers from each store if the objective is to minimize delivery costs and consequently maximize NPV. Assume that all demanded components must be delivered to customers in full and that no partial delivery of component is allowed (i.e. there should be no fraction of component). Assume further that it is possible to deliver all components to a particular store and nothing from other stores. Prepare the Excel table which shows the component delivery showing all formulas for all conditions necessary to achieve the company objective of minimizing delivery costs.

8. Using original data, recalculate the NPV associated with optimal delivery costs.