Question

Part B: Answer all the questions (15 marks each) Question 1: (15 marks) KB Machine Limited is considering investing $3 million in new machinery, Model X. If the new model is acceptable, the old machine will be disposed at $500,000 immediately. A feasibility study, completed by consultants at a cost of $300,000, has confirmed that the equipment will help increase output and improve quality. The expected sales so generated amount to $1 million per year over the life of the project. The equipment will depreciate on a straight-line basis to a zero book value over the estimated life of five years. Cost of goods sold and operating expenses related to the projects are predicted to be 20% of sales. An extra investment in inventory for spare parts and accessories of total $600,000 will be required at the beginning of the project and will be fully recovered at the end of the project. The corporation tax rate is 20% payable at end of the relevant year. Assume the cost of capital is 10% Required: (a) Explain why net present value is a superior method of investment analysis compared to the other valuation methods. 2 marks (b) What is the initial investment outlay of the project? 2 marks (c) i) What is the annual depreciation expense of the machinery? 1 marks ii) What are the earnings before interest and tax (EBIT) and annual cash flow of the project for the years 1 to 4? 3 marks iii) What is the terminal cash flow in Year 5? 2 marks (d) Compute the net present value of the project and the internal of return of the project? and advise whether the proiect is acceptable or not? 5 marks

Answer 1

a. NPV is considered a superior method of evaluating the cash flows from a project because it is able to rank projects of different sizes over varying periods of time to determine the most profitable course of action. ... It is the discount rate that is used to calculate a zero NPV for a series of cash flows.