PART B-Capital Budgeting

East West Bearings Ltd wants to expand its operations in Geelong. Considering the competitive environment and macro uncertainty, East West wants to make sure that they should invest professionally so that they would not suffer either on account of profits or on account of cash flows on any project. As the sales are growing consistently, to meet the projected sales, East West wants to set up a new plant to manufacture bearings. In this regard, the director of East West approaches you for your suggestions on their capital budgeting decision to set up a new bearings manufacturing plant.

The initial investment includes cash outlays for plant of $2 million, for equipment of $700,000, and for working capital of $300,000. Working capital will be deployed at initial stage and will be released at the end of the project. Project once started its cash revenue is projected worth $1.1 million for each of the 10 years of the project. Fixed cash expenses for this plant are $250,000 for each year. Variable cash expenses are $350,000 for first eight years of the operation, then in year 9 and 10 these become $360,000 for each of these years.

East West sells 50,000 bearings every year, starting from year 1 to year 10. Each bearing is sold for a price of $22 in all 10 operational years. Plant will be depreciated on a straight-line basis for 10 years. Equipment will be depreciated at a rate of $70,000 per annum for 10 years of operation. Corporate tax is levied at the rate of 30% per annum. At the expiry of 10 years, plant carries market value of $800,000 and is sold at this price while equipment is sold for $100,000. Working capital will be released at the expiry date. East West Bearings has a company policy to use 7% as the hurdle rate for all expansion investment opportunities. The hurdle rate is based on the study of the companys cost of capital conducted 3 years ago.

a. Prepare cash flow statement/s and compute the NPV and IRR of the proposed project. Comment on the feasibility of the project. (30 marks)

b. The director of East West Bearings forgot to mention one important expenditure which their company has incurred in relation to the establishment of this new plant. This expenditure has taken place in the form of $55,000, which has been paid in two instalments or $27,500 on account of feasibility reports to Alpha Marketing Company. Feasibility report was used to explore marketability of their new bearings produced from the new plant. Both the instalments of $27,500 duly paid before the installation of the new plant in question. Now, once it has been told to your team, you need to demonstrate how you are going to take this feasibility amount into consideration for calculating Cash flows of the project as well as NPV of the plant? (5 marks)

c. Sensitivity Analysis

Sensitivity analysis is a method of assessing business risk. It shows how a change in one of the major operational variables impacts business performance. Considering macroeconomic uncertainty in the future, the director of East West further advises you that you must take into consideration the sensitivity of sales and variable expenses in various economic conditions. Keeping into account the following variables, what will be your updated recommendations on the acceptance of this project using NPV as a decision criterion and using 8% as a discount factor?

i) If volume of sales goes up by 10% in year 7, 8, 9 and 10 while sales in year 1-6 remain the same as shown in Part-A of the assignment. (4 marks)

ii) If volume of sales goes down by 5% in year 5, 6, 7 and further by 10% in year 8, 9, and 10 while sales of the remaining years stay the same as shown in Part-A of the assignment. (4 marks)

iii) If volume of sale remains the same as in part a of the assignment but selling price of bearing comes down to $20 across all the years. In the meantime, East West found that because market value of the second-hand plants is predicted to depreciate substantially, they can sell their plant only for $50,000. (7 marks)

Answers for bold questions.