Question 3 Expansion Ltd is a Hong Kong based confectionery producer. The company is currently evaluating a potential project to sell a new type of biscuit called CrunchCake. The project is expected to have a life of 4 years and the following information is available about the Crunch Cake project. a) Market research into the biscuits market and customer preferences was completed three months ago and the fee of HK$35,000 was paid last month. b) The estimated cost of machinery to produce the Crunch Cake is HK$3,000,000. HK$500,000 of this machinery is already owned by Expansion Ltd and is currently unused. After the project, this set of old machinery will be retained in the company as it will have little resale value and so there is no tax effect from the use of the old machinery. The rest of the machinery will be new and needs to be bought in. The new machinery will be sold at the end of the project for HK$500,000. c) Capital allowances can be claimed on the whole of the cost of the new machinery at 18% reducing balance. d) An increase in fixed overheads due to the production of Crunch Cake will amount to HK$480,000 each year. e) Advertising spending is budgeted for HK$500,000 for Year 1, decreasing by 10% each year. Advertising expenditure will be paid at the beginning of each year. f) Expansion Ltd anticipate selling the patent for the CrunchCake making process for HK$2,000,000 at the end of Year 4. This sale will not have any tax effects. g) It is estimated that on average 2,500,000 packs of Crunch Cake will be sold each year. The contribution from each pack of Crunch Cake is estimated to be HK$0.55 in Yea 1, rising by 5% each year thereafter. h) Working capital needed at the beginning of the project will be HK$300,000, increasing by 5% year-on-year. This will all be repaid when production ceases. i) Tax is paid at 25% in the year the cashflow arises. j) Expansion Ltd has a 12% cost of capital. Required: (A) Calculate the Net Present Value (NPV) of the CrunchCake project, then state whether the project should go ahead and why. (12 Marks) (B) Using your answer to (A) and performing additional calculations, identify the Internal Rate of Return (IRR) of the CrunchCake project and comment whether the IRR will influence your recommendation stated in (A). (4 marks) (C) You are required to prepare a report for the management of Expansion Ltd to help them arrive at a decision on the Crunch Cake project. Your report should cover the following: i. A brief explanation of the NPV appraisal method and why NPV is considered as a technically superior technique for investment appraisal, and hence why your recommendations stated in (A) should be followed by the managers. ii. Identify TWO key assumptions which underline your calculations of the NPV for the Crunch Cake project that are likely to have a large degree of uncertainty. For each of the two assumptions, briefly explain the uncertainty involved and how it could impact on your calculations and thus your recommendations. You are NOT required to perform additional calculations to answer part (C). Word count guidance for Part (C): 300-350 words (9 marks) Question 3 Expansion Ltd is a Hong Kong based confectionery producer. The company is currently evaluating a potential project to sell a new type of biscuit called CrunchCake. The project is expected to have a life of 4 years and the following information is available about the Crunch Cake project. a) Market research into the biscuits market and customer preferences was completed three months ago and the fee of HK$35,000 was paid last month. b) The estimated cost of machinery to produce the Crunch Cake is HK$3,000,000. HK$500,000 of this machinery is already owned by Expansion Ltd and is currently unused. After the project, this set of old machinery will be retained in the company as it will have little resale value and so there is no tax effect from the use of the old machinery. The rest of the machinery will be new and needs to be bought in. The new machinery will be sold at the end of the project for HK$500,000. c) Capital allowances can be claimed on the whole of the cost of the new machinery at 18% reducing balance. d) An increase in fixed overheads due to the production of Crunch Cake will amount to HK$480,000 each year. e) Advertising spending is budgeted for HK$500,000 for Year 1, decreasing by 10% each year. Advertising expenditure will be paid at the beginning of each year. f) Expansion Ltd anticipate selling the patent for the CrunchCake making process for HK$2,000,000 at the end of Year 4. This sale will not have any tax effects. g) It is estimated that on average 2,500,000 packs of Crunch Cake will be sold each year. The contribution from each pack of Crunch Cake is estimated to be HK$0.55 in Yea 1, rising by 5% each year thereafter. h) Working capital needed at the beginning of the project will be HK$300,000, increasing by 5% year-on-year. This will all be repaid when production ceases. i) Tax is paid at 25% in the year the cashflow arises. j) Expansion Ltd has a 12% cost of capital. Required: (A) Calculate the Net Present Value (NPV) of the CrunchCake project, then state whether the project should go ahead and why. (12 Marks) (B) Using your answer to (A) and performing additional calculations, identify the Internal Rate of Return (IRR) of the CrunchCake project and comment whether the IRR will influence your recommendation stated in (A). (4 marks) (C) You are required to prepare a report for the management of Expansion Ltd to help them arrive at a decision on the Crunch Cake project. Your report should cover the following: i. A brief explanation of the NPV appraisal method and why NPV is considered as a technically superior technique for investment appraisal, and hence why your recommendations stated in (A) should be followed by the managers. ii. Identify TWO key assumptions which underline your calculations of the NPV for the Crunch Cake project that are likely to have a large degree of uncertainty. For each of the two assumptions, briefly explain the uncertainty involved and how it could impact on your calculations and thus your recommendations. You are NOT required to perform additional calculations to answer part (C). Word count guidance for Part (C): 300-350 words (9 marks)
