Question

Question 4 (20 marks)

MC Noodle is a local company that makes instant noodles. Last year, the company spent $88,000 hiring a marketing consultant to evaluate whether or not a new line of phat mama (stir-fried instant noodles) should be launched. The consultant finds that the new product will be able to generate $520,000 of additional sales revenue per year for the company. Production of the new product will involve the following activities:

 A new machine has to be purchased prior to commencement of production. The new machine will cost $660,000 and has a useful life of four years. For tax purposes, assume the new machine would be fully depreciated by the straight-line method over a period of four years.

 If the company accepts this project, the annual cash expenses of the company will increase by $270,000.

 The project will necessitate an increase in net working capital of $233,000.

 To purchase the new machine, it appears that the company has to borrow $500,000 at

6% interest from its bank, resulting in additional interest expenses of $30,000 per year.

Furthermore, the marginal tax rate and the required rate of return for the company are 25% and 10% respectively.

Required:

(a) Determine the annual after-tax cash flows associated with this project.

(b) Determine whether you would accept the project if the profitability index rule is used.

(c) Without doing any calculation, critically discuss whether your decision will change if the net present value rule is used instead of the profitability index rule. Are there any circumstances under which using the net present value rule is more appropriate than the profitability index rule? Explain. (word limit: 150 words)

Answer 1

Machine Cost = $660,000

New machine would be fully depreciated by the straight-line method over a period of four years.

Annual Depreciation = $660,000 / 4 = $165,000

Assumption:

• $233,000 working capital will be recovered at the end of project life
• 0 Salvage Value of machinery at the end of project life

Ans (a) Annual after-tax cash flows associated with this project.

		0	1	2	3	4
1	Initial Cost	-660000
2	Additional Revenue		520000	520000	520000	520000
3	Additional Cash Expenses		270000	270000	270000	270000
4	Depreciation		165000	165000	165000	165000
5	Interest Expenses		30000	30000	30000	30000
6	Profit Before Tax (2-3-4-5)		55000	55000	55000	55000
7	Tax @ 25% (6 * 0.25)		13750	13750	13750	13750
8	Profit After Tax (6 - 7)		41250	41250	41250	41250
9	Cash From Operations (8 + 4)		206250	206250	206250	206250
10	Change in Working Capital	-233000				233000
11	Total Cash Flow	-893000	206250	206250	206250	439250

Ans (b)

Profitability Index = PV of Future Cash Flows / Initial Investment

PV of Future Cash Flows = $812,926.88 (Kindly Refer Below Table for Detail Calculation)

Initial Investment = $893,000 (Which is sum of Initial Cost of Machine plus Change in Working Capital, $660,000 + $233,000)

Profitability Index = $812,926.88 / $893,000 = 0.9103

As Profitability Index is 0.9103 which is less than 1 so project should not be accepted. As per Profitability Index project should have atleast 1 value to get the acceptance.

		0	1	2	3	4
1	Initial Cost	-660000
2	Additional Revenue		520000	520000	520000	520000
3	Additional Cash Expenses		270000	270000	270000	270000
4	Depreciation		165000	165000	165000	165000
5	Interest Expenses		30000	30000	30000	30000
6	Profit Before Tax (2-3-4-5)		55000	55000	55000	55000
7	Tax @ 25% (6 * 0.25)		13750	13750	13750	13750
8	Profit After Tax (6 - 7)		41250	41250	41250	41250
9	Cash From Operations (8 + 4)		206250	206250	206250	206250
10	Change in Working Capital	-233000				233000
11	Total Cash Flow	-893000	206250	206250	206250	439250
12	Required Rate of Return @ 10%
13	PV = Discounting Total Cash Flow by 10%	-893000	187500	170454.5455	154958.6777	300013.6603
14	PV of Future Cash Inflows	812927
15	PV of Initial Investment	893000

Ans (c)

Decision of accepting the project won't change as less than 1 Profitability Index project would give negative NPV because we get less than 1 Profitability Index only if PV of Inflows and less than initial cost of the project so this project has PV of future inflows less than initial investment hence project should be rejected based on NPV analysis.

Profitability Index signify if the project has PV of inflows higher than initial investment or not but Profitability Index couldn't help in identifying the quantum of inflows.

A project with small outflows and not adding significant value to the sales of the firm is giving PV of inflows greater than initial investment however as this is not making significant impact on the top line of the overall revenue of the company. Such project can have Profitability Index on higher side as there is low initial investment however a project with major significant size of initial investment and significant revenue addition to top line can have little lesser Profitability Index than the small project so Profitability Index prioritize the small project based on the Profitability Index ranking however it ignore the quantum of the Present Value of Inflows so Profitability Index is useful only for similar size of projects.

Example Project A with Initial investment of $1000 and PV of Inflows is $1500

Profitability Index = 1500/1000 = 1.5

Project B with Initial investment of $1,000,000 and PV of Inflows is $1,400,000

Profitability Index = $1,400,000/$1,000,000 = 1.4

As per PV Project is having higher Profitability Index but this is adding very small inflows to the firm so Project B should be analyzed as per NPV .

Hope this helps. Thanks and have a good day. Feel free to share your feedback.

Are there any circumstances under which using the net present value rule is more appropriate than the profitability index rule? Explain.