Question

Please answer all question and workings.. Tq

UUSUT Evans Plc. is considering an investment in environmental technology that will reduce operating costs through increasing energy efficiency. The new technology will cost $1,800,000 and have a five-year life, at the end of which it will have a scrap value of $400,000 A government levy of $250,000 is payable during the first year. This levy will increase by 6% per year in each subsequent year. Environmental technology is expected to reduce operating costs by $10.00 per unit in current price terms. This reduction in operating costs is before taking account of expected inflation of 2% per year. Forecast production volumes over the life of the new technology are expected to be as follows: Year Production (Units Per Year) 70,000 80,000 60,000 60,000 The capital allowances on the investment are 25% on a reducing balance basis and the company pays taxation one year in arrears at an annual rate of 20% Bell Inc. has an after-tax weighted average cost of capital (WACC) of 12% per year. Required a) Using NPV Analysis, advise the Evans Pic on whether they should accept or reject this project (15 marks) b) Evaluate the impact use of the capital asset pricing model instead of WACC when selecting a project specific discount rate in investment appraisal. (10 marks) (Total: 25 Marks)

Answer 1

Assumption:

1.The useful life of the project is 5 years. but saving per unit is given only for 4 years. hence we assume that there is no benefit in last year

2. It is assume that the government levy is linked with project and hence irrespective of saving it will be levied till the project is continued.

4. It is assumed that capital allowance is in the nature of Depreciation and hence it will be reduced from total saving for tax calculation purpose

3. NPV is calculated using after tax discount rate

Working for capital allowance on YoY

Year	Opening Balance	Capital Allowance	Closing balance
1	1800000.00	450000.00	1350000.00
2	1350000.00	337500.00	1012500.00
3	1012500.00	253125.00	759375.00
4	759375.00	189843.75	569531.25
5	569531.25	142382.81	427148.44

Year	Number of Unit	Saving per Unit	Total Saving	Capital Allowance	Government Levy As increased by 6% p.a.	Net Saving	Taxes - (Net saving *20/100)	PAT (net Saving-Taxes)	Cash flow (PAT+Capital Allowance)	Discount rate @ 12% p.a.	Discounted Cash Flow
0									-1800000	1	-1800000.00
1	70000	10	700000	450000	250000	0	0	0	450000	0.8929	401805.00
2	80000	10.2	816000	337500	265000	213500	42700	170800	508300	0.7972	405216.76
3	60000	10.4	624000	253125	280900	89975	17995	71980	325105	0.7118	231409.74
4	60000	10.61	636600	189843.75	297754	149002.3	29800.45	119201.8	309045.55	0.6355	196398.45
5	0	10.82	0	142382.813	315619.24	-458002	-91600.4	-366402	-224018.83	0.5674	-127108.28
5	Scrape Value at the end of useful life			0	0	0	0	0	400000	0.5674	226960.00
	NPV considering after tax discount rate										-465318.34

CAPM V/s WACC

Following points are worth noting for evaluation purpose.

• WACC can be used as a discounting tool where the investment project is small as compared to total investment of in company. While we can use CAPM model for  project specific discount rate.
• To use WACC as discounting tool, The investment project activity must be similar to existing business activity. On the other hand as CAPM use project specific there is no need of similarity.
• It might be possible that project evaluated through WACC may be rejected and Evaluation made through CAPM may in favor of project.