Question
Zoolander Ltd has undertaken market research at a cost of 500,000 to assess the feasibility of a number of projects as part of its expansion
Zoolander Ltd has undertaken market research at a cost of 500,000 to assess the feasibility of a number of projects as part of its expansion strategy. After careful consideration, the board of directors has requested for a more detailed analysis on two of the projects below. Information related to the cash flows (sales revenue and costs) from each of the two projects are provided below:
Project 1
Year | 1 | 2 | 3 | 4 | 5 |
Incremental Sales Revenue (000's) | 2,000 | 2,500 | 2,600 | 1,800 | 1,800 |
Incremental Costs (000's) | 1,000 | 1,100 | 1,200 | 900 | 920 |
Project 2
Year | 1 | 2 | 3 | 4 | 5 |
Incremental Sales Revenue (000's) | 1,000 | 1,200 | 1,500 | 1,400 | 1,400 |
Incremental Costs (000's) | 400 | 500 | 600 | 600 | 500 |
All the forecast cash flows above should be assumed to occur at the end of the year. They have also been provided in current terms, i.e., the values are based in year zero. Both the forecast revenues and costs should therefore be inflated by the general rate of inflation of 5% per year.
Additionally, each project will require working capital investment equal to 10% of the expected sales revenue. This investment must be in place at the start of each year.
The two projects will also require initial capital investment on new machinery of 3 million for project 1 and 2 million for project 2. These investments are payable at the start of the first year. Both of these investments will attract capital allowances (tax allowable depreciation) of 25% on a reducing balance basis. At the end of year 5, the machinery used on both projects will have a zero-scrap value.
Zoolander Ltd pays tax on profits at an annual rate of 30% per annum. Half of the tax due in any one year is paid in the same year while the other half is paid the year after. The company uses a nominal (money terms) after tax cost of capital of 20% per year to evaluate these types of projects.
REQUIRED
(a) Calculate the net present value for each of the two projects and advise the board of Zoolander Ltd which one should they proceed with. You should show all your workings.
(b) Assume that the 2 projects above are not mutually exclusive and are divisible, i.e., Zoolander can undertake a portion of each of the projects. Calculate the maximum net present value that Zoolander Ltd can achieve if the maximum amount of investment available is 3 million.
(c) Critically discuss whether the board of Zoolander Ltd should go ahead with either of the 2 projects you have evaluated.
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