The management of Eagle industries is considering whether to build a factory in the UK

in order to manufacture a new type of protective cover for smartphones. They already own

a convenient site for the new factory in a development area, but this could be sold for

100,000 if the project does not proceed.

Going ahead with the project would involve the

following outlays:

Building: 1,000,000

Plant 500,000

Machinery 700,000

Working capital (once full capacity is reached) 500,000

The project will require one year for building and installation although the capital costs for

buildings, plant and machinery must be paid immediately the project gets the go-ahead.

The plant and machinery will have an estimated economic life of five years and a terminal

scrap value of 100,000.

The total market for this type of smartphone cover is forecast to be fairly static at some

10 million units per year.

The company hopes to capture some 10 percent of the market by its third year of production

and in the first two years it is forecasting market shares of 2% and 5% respectively.

The planned selling price for the new cover is 10 per unit.

Total operating costs including raw materials, wages, factory overheads, administration,

distribution and selling are forecast at 2.5 million in year 1, 4.6 million in year two and

8.5 million thereafter. In addition, there are launch costs (advertising and promotion) of

200,000 in year 1 and 100,000 in year 2. Research and development, which has now

been completed, has cost a total of 500,000 over the past two years. You should assume

that inflation is zero.

At the end of the five-year production period, it is anticipated that this particular type of

smartphone cover will have been made obsolete as a result of technological change.

Since the building required is a special purpose structure, it will have no alternative use at this

time, although it could be demolished at a cost that would be close to its scrap value. It is

estimated that the value of the land (with or without the building) will be 140,000 at this

time.

If the land were to be sold, either now or in the future, the sale proceeds would be

taxed at 20%.

The company anticipates that it will continue to pay corporation tax for the foreseeable

future and the company's tax rate is 20%.

Assume that tax depreciation for industrial buildings and for plant and machinery is straight line over five

years. There is a tax-free grant of 15% on the value of the investment in buildings, plant

and, machinery. The team evaluating the project needs to complete Eagle Industries' standard project

appraisal.

This involves setting out the year-by-year cash flows anticipated from the

project, and then estimating the project's net present value (NPV) as the basis for deciding

whether to go ahead. NPVs are normally calculated at Eagle's cut-off rate of 10 percent,

but since there is currently some debate about whether 10 percent is really the appropriate

figure, project proposers are also requested to compute the project's internal rate of return.

Indeed, for good measure the standard project appraisal procedure also requires the

payback period since this measure is also favored by one or two members of the board.

Assignment

Carry out a project appraisal and, calculate the project's post-tax cash flows and,

from these, the NPV, the internal rate of return (IRR) and the payback period.

Remember to include the tax implications.