Question
Xerox Ltd has decided to purchase a new machine at a cost of 1,600,000, which is payable immediately. The machine has an expected useful life
Xerox Ltd has decided to purchase a new machine at a cost of 1,600,000, which is payable immediately. The machine has an expected useful life of five years, after which time it will be sold for scrap at an expected scrap value of 5% of the initial purchase cost. Additional investment of 180,000 in working capital will be needed at the start of the first year of operation this can be assumed to be released at the end of the project.
The machine is forecast to produce 100,000 units per year, representing the expected unit sales. The selling price per unit will be 32 and there will be variable costs of 22 per unit. Incremental fixed costs totalling 320,000 per year will also be incurred for the lifetime of the machine.
Xerox Ltd has a post-tax cost of capital of 10%, which is the discount rate used for investment appraisal purposes. The company pays tax in the year it is earned at an annual rate of 20%. Capital allowances and inflation should be ignored to evaluate this investment
1. Calculate of both the NPV (net present value) and the IRR (internal rate of return) of the proposed investment and advise the company on whether it should be accepted or not, and;
2. Explain the term 'sensitivity analysis', using the spreadsheet to illustrate the numerical sensitivity of the investment in the new machine to a change in the selling price and to a change in the discount rate (a second NPV using a discount rate of 15% should be used) and a commentary on your findings. Please also explain how exposure to these two risks could be mitigated in reality.
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