Question

The Board of Quest plc is due to meet to consider investing in a new project which will allow the company to diversify its existing product range. Before the meeting the Finance Director, has asked you, to evaluate the project using the following information.

Market research has been undertaken at a cost of HK$500,000 which shows that the project will result in the following cash flows:

	Year 1	Year 2	Year 3	Year 4
Sales volume (units)	100,000	130,000	130,000	90,000
Selling price (HK$/unit)	472	523	551	660
Variable cost (HK$/unit)	275	315	351	403
Fixed costs (HK$)	8,760,000	9,030,000	9,320,000	9,610,000

These forecasts are after taking account of selling price inflation of 3·0% per year, variable cost inflation of 6·0% per year and fixed cost inflation of 3·5% per year.

In addition included in the fixed costs is a figure of HK$1,000,000 which represents an apportionment of general overheads. The balance of the fixed costs are incremental fixed costs which are associated with the new project.

The total machinery costs of the project in year 0 are estimated to be HK$40,000,000 and the machinery from the project will be sold for scrap with a value of HK$4,000,000 at the end of year 4.The company will also have to spend HK$ 3,000,000 refurbishing the building before the new machinery can be installed.

Quest plc pays corporation tax of 25% per year. This is paid in the following year (i.e. one year in arrears) Capital allowances on an 18% reducing balance basis are available on the machinery only. A balancing charge or allowance is available at the end of the fourth year of operation.

Quest plc has a real cost of capital of 9% and the general rate of inflation is 3.7%

Required:

1. Calculating the nominal after-tax Net Present Value of the new project using the money cost of capital.(Round to the nearest whole number), calculating the Internal Rate of Return of the new project.

Answer 1

Nominal Cashflows are given.

Nominal Cost of capital = (1+Real Cost of capital)(1+Inflation Rate)-1

=(1+0.09)(1+0.037)-1 = (1.09*1.037)-1 = 0.1303 = 13.03%

Calculation of Nominal NPV and IRR:

Initial Investment
Total Machinery Cost	HK$4,00,00,000
Refurbishing cost	HK$30,00,000
	HK$4,30,00,000
Depreciation Allowance
Year	1	2	3	4
Opening Machinery	HK$4,00,00,000	HK$3,28,00,000	HK$2,68,96,000	HK$2,20,54,720
Dep. @ 18% RBM	HK$72,00,000	HK$59,04,000	HK$48,41,280	HK$39,69,850
Closing	HK$3,28,00,000	HK$2,68,96,000	HK$2,20,54,720	HK$1,80,84,870
Terminal Value
Scrap Value	HK$40,00,000.0	(in year 4)
Book Value	HK$1,80,84,870.4
Loss	HK$1,40,84,870.4
Tax Saving on loss @ 25%	HK$35,21,217.6	(in year 5)
Total Gain	HK$75,21,217.6	=4000000+3521218
Cashflows
Year	1	2	3	4	5	Total
Sales (units)	100000	130000	130000	90000
S.P p.u	HK$472	HK$523	HK$551	HK$660
Total Sales	HK$4,72,00,000	HK$6,79,90,000	HK$7,16,30,000	HK$5,94,00,000
Variable cost p.u	HK$275	HK$315	HK$351	HK$403
-Total Variable cost	-HK$2,75,00,000	-HK$4,09,50,000	-HK$4,56,30,000	-HK$3,62,70,000
-Incremental Fixed Cost excl. General Ohs	-HK$77,60,000	-HK$80,30,000	-HK$83,20,000	-HK$86,10,000
-Depreciation Allowed	-HK$72,00,000	-HK$59,04,000	-HK$48,41,280	-HK$39,69,850
PBT	HK$47,40,000	HK$1,31,06,000	HK$1,28,38,720	HK$1,05,50,150
-Tax @ 25% in next year	-	-HK$11,85,000	-HK$32,76,500	-HK$32,09,680	-HK$26,37,538
+Depreciation	HK$72,00,000	HK$59,04,000	HK$48,41,280	HK$39,69,850
Net Cashflow	HK$1,19,40,000	HK$1,78,25,000	HK$1,44,03,500	HK$1,13,10,320	-HK$26,37,538
Terminal Gains				HK$40,00,000	HK$35,21,218
Total Cashflow	HK$1,19,40,000	HK$1,78,25,000	HK$1,44,03,500	HK$1,53,10,320	HK$8,83,680
PV Factor @ 13.03%	HK$1	HK$1	HK$1	HK$1	HK$1
PV of Cashflows	HK$1,05,63,567	HK$1,39,52,180	HK$99,74,402	HK$93,80,141	HK$4,78,990	HK$4,43,49,280
-Initial Investment						-HK$4,30,00,000
Nominal NPV						HK$13,49,280
Nominal IRR (using IRR Function)	14.47%