Q 2

The directors of Pelta Co are considering a planned investment project costing $25m, payable at the start of the first year of operation. The following information relates to the investment project: Yr1 Yr2 Yr3 Yr4 Sales volume (units/year) 520,000 624,000 717,000 788,000

Selling price ($/unit) 30.00 30.00 30.00 30.00

Variable costs ($/unit) 10.00 10.20 10.61 10.93 Fixed cost ($/year) 700,000 735,000 779,000 841,000

This information needs adjusting to take account of selling price inflation of 4% per year and variable cost inflation of 3% per year. The fixed costs, which are incremental and related to the investment project, are in nominal terms. The year 4 sales volume is expected to continue for the foreseeable future.

P and Co pays corporation tax of 30% one year in arrears. The company can claim tax- allowable depreciation on a 25% reducing balance basis. The views of the directors of P andCo are that all investment projects must be evaluated over four years of operations, with an assumed terminal value at the end of the fourth year of 5% of the initial investment cost. Both net present value and discounted payback must be used, with a maximum discounted payback period of two years. The real after-tax cost of capital of Pelta Co is 7% and its nominal after-tax cost of capital is 12%.

Required:

A. Calculate the net present value and the discounted payback period of the planned investment project using the nominal after-tax cost of capital.

B. Discuss the financial acceptability of the investment project.

C. Critically discuss the views of the directors on P and Cos investment appraisal.