Question

Olourun Ltd is the major employer in the Front Hill area, where the firm is located. The company is considering the acquisition of a new production line. The equipment would cost $$720000$ and installation cost would amount to $$59000.$ At the end of its $5-$year life, it is expected to be disposed of at its salvage value of $$70000.$ The new equipment would allow the company to expand production significantly, which would require an increase in working capital of $$90000.$ If the purchase is made, the firm's maintenance costs would be reduced by $$60000$ annually. However, at the end of the third year, a major overhaul would have to be undertaken at a cost of $$80000.$ Operating cash flows would be $$220000$ in the first year; this would increase by $2\%$ for each of the following years.

The company's cost of capital is $14\%$ and the relevant corporate tax rate is $25\%$

a$)$ Calculate the relevant after$-$tax net cash flows and after$-$tax profits over the life of the investment. $[10$ marks$]$

b$)$ Compute the project's ARR$[5$ marks$]$

c$)$ What is the payback period?$[5$ marks$]$

d$)$ Using the NPV as the basis of your decision, advise Olourun as to whether the company should purchase the equipment.$[7$ marks$]$

e$)$ Would you advise the company to base their decision on the payback method rather than the NPV as used above? $[5$ marks$]$

f$)$ Compute the IRR of the project$[12$ marks$]$

g$)$ The company is considering another investment which would have an initial cost of $$800000$ and an NPV of $$65000.$ There is a situation of capital rationing, and you have suggested that the firm should use the profitability index to choose which investment to implement. Advise the company.$[7$ marks$]$

h$)$ Discuss THREE non$-$financial factors which the firm should consider when making this decision.$[9$ marks$]$

i$)$ Why is it important for the company to know its cost of capital when making investment decisions?$[5$ marks$]$