Question

part b,c or d

You are required to answer all parts of ONE out of THREE questions in this section Question 2 New Pic is considering whether to replace existing machineries. This will require an initial investment of £1.2 million. New machineries would have an expected We of six years. At the end of six years, they could be sold for £150,000. Replacement of machineries is expected to generate additional annual revenues of £400,000. The incremental costs are estimated to be 20% of the additional revenues for the first year and 15% of additional annual revenues for the rest of the project. New Plc is also considering a request form a large client to manufacture a new product. This will require a new investment of £800,000 in technology. The project wil last for six years and is expected to generate annual net cash flows of 200,000. It will not have any residual value at the end of its life. New Plc employs a discount rate of 12% and does not pay any corporation tax. Management team has decided to invest a limited capital of 1.5million in new projects. The two projects under consideration are independent and indivisible You are required to: a. Estimate the Net Present Value (NPV). Internal Rate of Return (IRR) and Payback Period (PP) techniques and recommend which project(s) the company should undertake. State any assumptions made, when applying these techniques. Show all the calculations (45 marks) (150-200 words) b. Suggest whether the recommended project(s) is more sensitive to initial investment or discount rate. Support your answer with the relevant estimations (15 marks) (50-100 words) c. Explain how your recommendation would have changed if both projects were divisible (10 marks) (50 - 100 words) d. Assume that company's discount rate of 12% is given in real terms, but new projects' cash flows are estimated in nominal terms. Assume that the annual inflation rate is expected to be 3%. Suggest whether your recommendation in part (a) will change (10 marks) (up to 50 words) BE NⓇ 9

Answer 1

(A)	Replace Option -
	Initial Investment =	1200000
	Useful Life =	6	Years
	Salvage Value at the end of life =	150000
	Increase in Annual Revenue =	400000
	Incremental Cost -
	for Year 1 =	20%	Of additional Revenue
	for Year 2 to 6 =	15%	Of additional Revenue
	Discount Rate =	12%
	Year	0	1	2	3	4	5	6
	Initial Investment	-                                       1,200,000
	Annual Revenue		400,000	400,000	400,000	400,000	400,000	400,000
	Incremental Expenses		-        80,000	-        60,000	-        60,000	-        60,000	-        60,000	-        60,000
	Salvage Value							150,000
	Net Cash Flows	-                                       1,200,000	320,000	340,000	340,000	340,000	340,000	490,000
	PV Factor @ 12%	1.00	0.89	0.80	0.71	0.64	0.57	0.51
	PV of Cash Flows	-                                       1,200,000	285,714	271,046	242,005	216,076	192,925	248,249
	NPV =	256,016
	Manufacture Option
	Initial Investment =	800000
	Useful Life =	6	Years
	Salvage Value at the end of life =	0
	Annual Net cash Flow	200000
	Incremental Cost -
	for Year 1 =	20%	Of additional Revenue
	for Year 2 to 6 =	15%	Of additional Revenue
	Discount Rate =	12%
	Year	0	1	2	3	4	5	6
	Initial Investment	-                                           800,000
	Annual Revenue		200,000	200,000	200,000	200,000	200,000	200,000
	Net Cash Flows	-                                          800,000	200,000	200,000	200,000	200,000	200,000	200,000
	PV Factor @ 12%	1.00	0.89	0.80	0.71	0.64	0.57	0.51
	PV of Cash Flows	-                                           800,000	178,571	159,439	142,356	127,104	113,485	101,326
	NPV =	22,281
(B)	The recommended project is replacement option project, we need to do sensitivity analysis on the project.
(i)	on Initial Investment
	Lets Increase the Initial Investment by 10%
	Initial Investment =	1320000
	Useful Life =	6	Years
	Salvage Value at the end of life =	150000
	Increase in Annual Revenue =	400000
	Incremental Cost -
	for Year 1 =	20%	Of additional Revenue
	for Year 2 to 6 =	15%	Of additional Revenue
	Discount Rate =	12%
	Year	0	1	2	3	4	5	6
	Initial Investment	-                                       1,320,000
	Annual Revenue		400,000	400,000	400,000	400,000	400,000	400,000
	Incremental Expenses		-        80,000	-        60,000	-        60,000	-        60,000	-        60,000	-        60,000
	Salvage Value							150,000
	Net Cash Flows	-                                       1,320,000	320,000	340,000	340,000	340,000	340,000	490,000
	PV Factor @ 12%	1.00	0.89	0.80	0.71	0.64	0.57	0.51
	PV of Cash Flows	-                                       1,320,000	285,714	271,046	242,005	216,076	192,925	248,249
	NPV =	136,016
	Change in Initial investment =	10%
	Change in NPV =	(256016-136016)/256016 x 100=	46.9%
(ii)	on Discount Rate
	Lets Increase the Discount Rate by 10%
	Initial Investment =	1320000
	Useful Life =	6	Years
	Salvage Value at the end of life =	150000
	Increase in Annual Revenue =	400000
	Incremental Cost -
	for Year 1 =	20%	Of additional Revenue
	for Year 2 to 6 =	15%	Of additional Revenue
	Discount Rate =	13.20%
	Year	0	1	2	3	4	5	6
	Initial Investment	-                                       1,320,000
	Annual Revenue		400,000	400,000	400,000	400,000	400,000	400,000
	Incremental Expenses		-        80,000	-        60,000	-        60,000	-        60,000	-        60,000	-        60,000
	Salvage Value							150,000
	Net Cash Flows	-                                       1,320,000	320,000	340,000	340,000	340,000	340,000	490,000
	PV Factor @ 13.20%	1.00	0.88	0.78	0.69	0.61	0.54	0.48
	PV of Cash Flows	-                                       1,320,000	282,686	265,330	234,390	207,059	182,914	232,872
	NPV =	85,250
	Change in Discount =	10%
	Change in NPV =	(256016-85250)/256016 x 100=	66.7%
	The Change in Discount rate Causes more change in NPV hence the discount rate is more sensitive.
( C )	Since the NPV of both the projects is positive, both the projects are acceptable.
	In part a we recommended project 1st (i.e. Replacement project) because it has better NPV.
	Since the projects are now divisible, we can invest 1.2 Million in replacement project and the rest 1.5 - 1.2 = 0.3 Million can be invested in the manufacturing project.
(D)	To evaluate the options both cashflows and discount rate should be same, either both should be in real terms or in nominal terms.
	Since the cashflows are nominal we need to convert the Discount rate to Nominal rate also.
	Nominal interest Rate =	((1+Real Rate)X (1+Inflation Rate)) -1
		((1.12)X(1.03))-1
		15.36%
	Replace Option -
	Initial Investment =	1200000
	Useful Life =	6	Years
	Salvage Value at the end of life =	150000
	Increase in Annual Revenue =	400000
	Incremental Cost -
	for Year 1 =	20%	Of additional Revenue
	for Year 2 to 6 =	15%	Of additional Revenue
	Discount Rate =	15.36%
	Year	0	1	2	3	4	5	6
	Initial Investment	-                                       1,200,000
	Annual Revenue		400,000	400,000	400,000	400,000	400,000	400,000
	Incremental Expenses		-        80,000	-        60,000	-        60,000	-        60,000	-        60,000	-        60,000
	Salvage Value							150,000
	Net Cash Flows	-                                       1,200,000	320,000	340,000	340,000	340,000	340,000	490,000
	PV Factor @ 15.36%	1.00	0.87	0.75	0.65	0.56	0.49	0.42
	PV of Cash Flows	-                                       1,200,000	277,393	255,487	221,469	191,981	166,419	207,905
	NPV =	120,653
	Manufacture Option
	Initial Investment =	800000
	Useful Life =	6	Years
	Salvage Value at the end of life =	0
	Annual Net cash Flow	200000
	Incremental Cost -
	for Year 1 =	20%	Of additional Revenue
	for Year 2 to 6 =	15%	Of additional Revenue
	Discount Rate =	15.36%
	Year	0	1	2	3	4	5	6
	Initial Investment	-                                           800,000
	Annual Revenue		200,000	200,000	200,000	200,000	200,000	200,000
	Net Cash Flows	-                                          800,000	200,000	200,000	200,000	200,000	200,000	200,000
	PV Factor @ 15.36%	1.00	0.87	0.75	0.65	0.56	0.49	0.42
	PV of Cash Flows	-                                           800,000	173,370	150,286	130,276	112,930	97,893	84,859
	NPV =	-                                             50,385
	The NPV of the replacement option is still better then the other option, so our recommendations would not change.