Question

Wellcome Technologies PLC, a biotech company, has asked you to evaluate the following project for the production of a new product The firm has spent £200,000 per year on developing this new product for the last 3 years. You are going to charge a fee of £20,000 to undertake the project evaluation. It will be necessary to invest £2.5m in a piece of new machinery immediately. It has been estimated that expected sales are 50000 items of the new product in years 1, 2, 3 and 4 but nothing thereafter. In year 1 you expect items to sell at £50 per item in nominal terms. The nominal total costs of production will be £3,500,000 in year 1. In addition, head office costs will rise because it will be necessary to recruit three new employees on a four-year contract to oversee the project at a starting cost to the firm of £110,000. The project will also be allocated additional costs from the product marketing of £100,000 of head office costs in the first year Question 1 continued/.... Page 1 of 4 Question 1 continued You expect sales revenues and all costs and allocations to rise in line with inflation for years 2, 3 and 4 . Inflation is expected to be 4% per annum. At the end of the fourth year the machinery can be resold for £1,500,000. Working capital is held by the company which is 12.5% of the annual sales. (a) Identify the relevant incremental pre-tax cash flows associated with the project. (30 marks) (b) Assume that Wellcome Technologies PLC is a consistently profitable company. It pays corporation tax at a rate of 25%. For calculating capital allowances for taxation purposes, assume that the new piece of machinery can be depreciated at 20% on a straight-line basis with the first allowance coming immediately (year 0). Identify the relevant post-tax cash flows associated with this project for each year (25 marks) (c) You need to estimate the discount rate for this project. of Wellcome Technologies PLC is 10% and itcan borrow at a pre-tax rate of 3%. It has a target debt to equity ratio (DVE) of 0.6 and is planning on funding this project via a new debt issue. The expected equity return What is the appropriate weighted average cost of capital? What is the NPV of this project? Should Wellcome Technologies PLC go ahead with the project? (25 marks) (d) Why it is important to conduct sensitivity analysis when undertaking capital budgeting? Whch variable do you think the NPV in this case will be most sensitive to?

Answer 1

Sol (a) Workings for the solution is as under:-

Projected Pre Tax Income Statement of Wellcome Technologies PLC
	Year 1	Year 2	Year 3	Year 4
Sales in Unit	50000	50000	50000	50000
Sales Price/ Unit	50.00	52.00	54.08	56.24	SP / unit rise in line with Inflation @ 4%
Revenues	2500000	2600000	2704000	2812160	Sales No * Sales Proce / Unit
Cost of Production	3500000	3640000	3785600	3937024	COP rise in line with Inflation @ 4%
Head Office Cost	110000	114400	118976	123735	Head of Cost rise in line with Inflation @ 4%
Product Marketing Cost	100000	104000	108160	112486.4	Product Marketing Cost rise in line with Inflation @ 4%
Total Incremental Cost	3710000	3858400	4012736	4173245	Total of Cost of Production +Head Office Cost and Product Marketing Cost
Incremental Pre Tax Profit	-1210000	-1258400	-1308736	-1361085
Incremental WC Requirement	-312500	-325000	-338000	-351520	Working Capital @ 12.5% of Incremental Sales
Time	Pre Tax Cash Flows
0	-2500000	Initial Outflow for investing in new machinery
1	-1522500	Adding Incremental Pre Tax Loss in this Case and Incremental WC Requirement
2	-1583400	Adding Incremental Pre Tax Loss in this Case and Incremental WC Requirement
3	-1646736	Adding Incremental Pre Tax Loss in this Case + Incremental WC Requirement
4	-1712605.44	Adding Incremental Pre Tax Loss in this Case and Incremental WC Requirement
4	1500000	Inflow from Re Selling of Machine in the end of this year 4

(b) The effect of Corporate Tax Rate and Depreciation has been worked below in the table due to space constraint we are adding just the changed areas of the Project Income Statement of the Company :-

	Year 1	Year 2	Year 3	Year 4
Depreciation	500000	500000	500000	500000	Depreciation @ 20% on SLM Basis on Cost of new Machine
Total Incremental Cost	4210000	4358400	4512736	4673245	Total of Cost of Production +Head Office Cost and Product Marketing Cost
Incremental Pre Tax Loss	-1710000	-1758400	-1808736	-1861085	Revenues Less Total Incremental Cost
Tax @ 25%	-427500	-439600	-452184	-465271	Corporation Tax @ 25% on Incremental Pre Tax Loss

Note:- Below we have worked Post Tax Cash Flows for the New Project the Tax Calculated is actually Tax Saving so it is an inflow rather than an outflow as overall the Company is profitable. The treatment for depreciation in Year 0 has also not been effected as it not a cash expense. Depreciation treatment for Year 1 to 4 has been made in the Income Statement as in the Post Tax Cash Flows it will be an inflow after the overall Tax Saving Figure is calculated.

Time	Post Tax Cash Flows
0	-2500000	Initial Outflow for investing in new machinery
1	-2022500	Adding Incremental Pre Tax Loss in this Case and Incremental WC Requirement
1	927500	Inflows from Adding Back Depreciation and Tax Savings of 427500 as company is overall profitable
2	-2083400	Adding Incremental Pre Tax Loss in this Case and Incremental WC Requirement
2	939600	Inflows from Adding Back Depreciation and Tax Savings of 439600 as company is overall profitable
3	-2146736	Adding Incremental Pre Tax Loss in this Case + Incremental WC Requirement
3	952184	Inflows from Adding Back Depreciation and Tax Savings of 452184 as company is overall profitable
4	-2212605.44	Adding Incremental Pre Tax Loss in this Case and Incremental WC Requirement
4	1500000	Inflow from Re Selling of Machine in the end of this year 4
4	965271.36	Inflows from Adding Back Depreciation and Tax Savings of 465271.36 as company is overall profitable

Sol (c) The Workings for WACC is as under:-

	Weighted Average Cost of Capital	Assuming	Wt	Cost	WACC
	Debt	60	0.375	2.25%	0.84%
	Equity	100	0.625	10%	6.25%
	Total Capital	160	1		7.09%
1	With D/E ratio as 0.6 we have to assume total equity as 100 thus total debt comes 60 and Total Capital 160
2	Weights are assigned by taking ratios of Debt to Total Capital and Equity to Total Capital
3	Cost of Equity is provided in the question and for Post tax Cost of Debt we assume Corporate Tax Rate as 25% thus 3%*(1-0.25) is cost of Debt
4	Multiplying the Weights with the Cost provides WACC adding both WACC equity & Debt Results in Appropriate WACC

NPV of the project is calculated on Post Tax Cash Flows calculated in part (b) with a Discount Factor which is our WACC i.e. 7.09% the NPV is the summation of all the Present Value of the Cash Flows derived from multiplying the Cash Flows with the Discount factor. The Working Table is pasted below:-

Time	Post Tax Cash Flows	DF @ 7.09%	Present Value of Cash Flows
0	-2500000	1.000	-2500000
1	-2022500	0.934	-1888598
1	927500	0.934	866093.9
2	-2083400	0.872	-1816665
2	939600	0.872	819304.2
3	-2146736	0.814	-1747962
3	952184	0.814	775307.7
4	-2212605.44	0.760	-1682319
4	1500000	0.760	1140501
4	965271.36	0.760	733928.5
	NPV of the project		-5300409

This project should not be undertaken unless the Cost of Production comes down. The NPV of this project is also negative to support the conclusion.

Sol (d): Sensitivity Analysis is important when undertaking capital budgeting exercise because we are projecting things for the future. Uncertainty is there while conducting capital budgeting exercise. The slight change in Cost of Production or Sale Price / Unit can change the cash flows significantly. Even the cost of capital or the discount factor is a major player in deciding the NPV of the projects thus the change in Macro levels or change in market perception towards return can dent the NPV of the project significantly making it unviable.

In this case NPV will be most sensitive to the Cost of Production amount.

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