Question 4 (20 marks)

MC Noodle is a local company that makes instant noodles. Last year, the company spent $88,000 hiring a marketing consultant to evaluate whether or not a new line of phat mama (stir-fried instant noodles) should be launched. The consultant finds that the new product will be able to generate $520,000 of additional sales revenue per year for the company. Production of the new product will involve the following activities:

A new machine has to be purchased prior to commencement of production. The new machine will cost $660,000 and has a useful life of four years. For tax purposes, assume the new machine would be fully depreciated by the straight-line method over a period of four years.

If the company accepts this project, the annual cash expenses of the company will increase by $270,000.

The project will necessitate an increase in net working capital of $233,000.

To purchase the new machine, it appears that the company has to borrow $500,000 at

6% interest from its bank, resulting in additional interest expenses of $30,000 per year.

Furthermore, the marginal tax rate and the required rate of return for the company are 25% and 10% respectively.

Required:

(a) Determine the annual after-tax cash flows associated with this project.

(b) Determine whether you would accept the project if the profitability index rule is used.

(c) Without doing any calculation, critically discuss whether your decision will change if the net present value rule is used instead of the profitability index rule. Are there any circumstances under which using the net present value rule is more appropriate than the profitability index rule? Explain. (word limit: 150 words)