XYZ Limited is a mamufacturer of transmissions and axles used in the harvesting equipment of the agricultumal industry. The manufacturing process is quite extensive, resulting in a vast amount of bulky steel scrap. The unprocessed stcel scrap is sold as a by-product of the manufacturing operation to various firms involved in the recycling process. The executive committee is currently evaluating whether to process the scrap into different grades and types of usable steel. Using various models of chip crushers, the scrap can be ground and compressed into either rough or fine scrap. The fine scrap would fetch a higher market price than the rough scrap. XYZ Limited has to decide whether to invest in the higher-cost chip crusher (HCC) to produce fine scrap or the lower-cost chip crusher (LCC) to produce rough scrap. As a financial analyst of the company, you have gathered relevant purchase prices and operating costs of the two chip crushers from the supplier of the chip crushers and the marketing and production staff. The key estimates of financial data for the two machines are given below: given below: \begin{tabular}{|l|c|c|} \hline & LCC & HCC \\ \hline Purchase Price & $400,000 & $480,000 \\ \hline Useful Life (years) & 4 & 6 \\ \hline Depreciation (reducing balance method) & 40% p.a. & 30% p.a. \\ \hline Salvage value at the end of useful life & $80,000 & $48,000 \\ \hline Annual interest expense & $48,000 & $48,000 \\ \hline Annual scrap revenue & $450,000 & $600,000 \\ \hline Annual operating costs: & & \\ \hline - Variable overheads & $50,000 & $150,000 \\ \hline - Salaries & $80,000 & $110,000 \\ \hline - Marketing & $45,000 & $60,000 \\ \hline \end{tabular} The calculation for annual operating costs includes the following items: a) Variable overheads are direct operating expenses incurred in the production of the fine or rough scrap. b) Salaries represent the costs of employing two new machine operators at a salary of $40,000 per annum each. For the HCC machine, the company will only need to employ a new machine operator and the second, who earns $70,000 per annum, will be transferred from the axle assembly plant. The second operator from the main plant would otherwise have been made redundant with a redundancy payment of $50,000. c) The marketing cost is based on the standard allocation of the new investment towards group advertising expenses, which is 10% of annual revenue. It has been estimated that the additional group advertising required to promote the sales of fine or rough scrap is only $40,000 per year. The accountant, Mr. Smith pointed out to you that the revenue figures do not take into consideration the scrap sales that XYZ would generate regardless of whether the company bought either machine. He has estimated that the current unprocessed scrap would generate a net income of $50,000 per year. Production facilities for the steel scrap would be set up in an unused section of XYZ Limited main plant. The section of the plant where the steel scrap production would occur has been unused for several years and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, XYZ Limited spent $80,000 to rehabilitate that section of the main plant. Mr. Smith believes this outlay, which has already been paid and expensed for tax purposes, should be charged to the steel scrap project. His contention is that if the rehabilitation had not taken place, the firm would have to spend $50,000 to make the site suitable for the steel scrap project. As the section of the plant has been rehabilitated, it could fetch a rental income of $40,000 per year. Production facilities for the steel scrap would be set up in an unused section of XYZ Limited main plant. The section of the plant where the steel scrap production would occur has been unused for several years and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, XYZ Limited spent $80,000 to rehabilitate that section of the main plant. Mr. Smith believes this outlay, which has already been paid and expensed for tax purposes, should be charged to the steel scrap project. His contention is that if the rehabilitation had not taken place, the firm would have to spend $50,000 to make the site suitable for the steel scrap project. As the section of the plant has been rehabilitated, it could fetch a rental income of $40,000 per year. The company's after tax cost of capital is 15 percent per annum. Assume that the company is subject to 30% corporate tax and that the tax is paid at end of the same year (i.e. not the following year). 1. Prepare cash flow tables (which incorporates taxes and includes initial investment, operating, and terminal cash flows) for each chip crusher. Compute net present value (NPV), payback period, NPV infinity, effective annual value (EAV) and internal rate of return to recommend either lower-cost chip crusher (LCC) or higher-cost chip crusher (HCC). [30 marks] 2. Undertake research to identify the qualitative factors (i.e. factors which are unquantifiable at present) that would affect the accept/reject decision of the project? [10 marks ] 3. It is necessary to check if the project made financial sense before it is accepted. Therefore, i) Conduct a sensitivity analysis of NPVs to change in the annual revenue and operating costs individually. Assume each of these variables can deviate from its estimated value by plus or minus 15%. [Hint: Provide the answers to this question even if you decide to reject the project.] ii) Analyse the effect of inflation on both machines. For simplicity, assume no other cash flows apart from the sales revenues and operating costs are affected. For both chip crushers, the sales revenues are expected to increase by the 5 percent rate beginning after Year 1. However, the annual operating costs are expected to increase by only 3 percent annually. [20+10=30 marks ] 4. Consider all information given in the case study and the results derived in Questions 1 to 3. Advise the executive committee on whether they should invest in an LCC or HCC. Discuss the reasons for your recommendation and the issues the XYZ Company needs to take into account, given this advice