Question 1

The finance director of Kievon Limited has recently proposed to the board, an expansion plan to produce hair straightening dryers. This will involve the purchase of new machinery; the initial outlay will be $4 million for the purchase of production machines. This outlay will be financed from the company's retained earnings, which could have been invested in a 5 years corporate bonds with a yield to maturity of 10%. An additional $200,000 installation is required to integrate the new machines to existing ones in the production line. The existing machines were acquired at a cost of $5 million five years ago.

Although the cash flows arising from this new product line is not easy to estimate, you have projected three sets of cash flow scenarios - pessimistic, probable, and optimistic. The director wishes to appraise all three scenarios in order to assess the impact of each scenario.

There is no scrap value for the machines at the end of useful life.

The cash flows projections are as follows:

Year (t)

1

2

3

4

5

Pessimistic

Cash Inflows

1,000,000

1,500,000

2,000,000

1,500,000

1,000,000

Cash Outflows

300,000

300,000

400,000

500,000

600,000

Probable

Cash Inflows

1,500,000

2,500,000

3,000,000

2,500,000

1,500,000

Cash Outflows

300,000

300,000

400,000

500,000

600,000

Optimistic

Cash Inflows

2,000,000

3,000,000

4,000,000

3,000,000

2,000,000

Cash Outflows

300,000

300,000

400,000

500,000

600,000

The company has a 12% cost of capital in all scenarios except for Optimistic view where cost of capital will be 10%.

Required:

(a)Calculate each scenario's Payback Period.

(b)Calculate each project's Net Present Value (NPV). Briefly discuss the result under the different scenarios

(c)Calculate each project's Profitability Index (PI). Briefly discuss the result under the different scenarios

(d)Critically evaluate the strengths and weaknesses of both the Net Present Value and Payback Period methods as a basis of evaluation for this project.

(e)The proposed new production could also be appraised with the Internal Rate of Return (IRR) method. Critically discuss the strength and weaknesses of the IRR method.