WhitePearl Berhad: Project Evaluation

It has been three months since you took a position as an assistant financial analyst at WhitePearl Berhad. Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves both the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects. Given your lack of tenure at WhitePearl Berhad, you have been asked not only to provide recommendations but also to respond to several questions aimed at judging your understanding of the capital budgeting process. The memorandum you received outlining your assignment follows:

To: The Assistant Financial Analyst

From: Mr. Mark, CEO WhitePearl Berhad

Re: Cash Flow Analysis and Capital Rationing

We are considering the introduction of a new product. Currently, we are in the 27% tax bracket with a 10% discount rate. The project is expected to last five years and then, it will be terminated. The following information describes the new project:

Cost of new plant and equipment RM 8,900,000

Shipping and installation costs RM 400,000

Unit Sales:

Year	Units Sold
1	70,000
2	120,000
3	140,000
4	80,000
5	60,000

Sales price per unit: RM300/unit in Years 1-4 and RM260/unit in Year 5

Variable cost per unit: RM180/unit

Annual fixed costs: RM300,000 per year

Working capital requirements:

There will be an initial working capital requirement of RM100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10% of the dollar value of sales for that year. Thus, the investment in working capital will increase during Years 1 through 3, then decrease in Year 4. Finally, all working capital is liquidated at the termination of the project at the end of Year 5.

Depreciation Method:

Straight line over five years assuming the plant and equipment have no salvage value after five years.

Question:

1. Why should WhitePearl Berhad focus on project free cash flows as opposed to the accounting profits earned by the project when analyzing whether to undertake the project?