Question 2

The directors of Bel and 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:

Year 1 Year 2 Year 3 Year 4

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 costs ($/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.

Bel 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 Bel Co 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 Bel 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 Bel Cos investment appraisal.