Question

Ocean Tide Industries is planning to introduce a new product with a projected life of eight years. The project is in the government’s preferred industry list and qualifies for a one-time subsidy of $2,000,000 at the start of the project. Initial equipment (IE) will cost $14,000,000 and an additional equipment (AE) costing $1,000,000 will be needed at the end of year 2. At the end of 8 years, the original equipment, IE, will have no resale value but the supplementary equipment, AE, can be sold for its book value of $100,000. A working capital of $1,500,000 will be needed.

The sales volume over the eight-year period have been forecast as follows:

Year 1 80,000 units 

Year 2 120,000 units 

Years 3-5 300,000 units 

Years 6-8 200,000 units 

A sale price of $100 per unit is expected and the variable expenses will amount to 40% of sales revenue. Fixed cash operating expenses will amount to $1,600,000 per year. 

Additionally, an extensive advertising campaign will be launched, which will need annual expenses as follows: 

Year 1 $3,000,000 

Year 2 $1,500,000 Years 3-5 $1,000,000 

Years 6-8 $400,000 

The company falls in the 50% tax category and believes 12% to be an appropriate estimate for its after-tax cost of capital for a project of this nature. All equipment is depreciated on a straight- line basis. In the event of a negative taxable income, the tax is computed as usual and is reported as a negative number, indicating a reduction in loss after tax. 

You are required to: 

1. Compute the initial cash flow for the project – 2 marks 

2. Compute the earnings before taxes for years 1 through 8 – 2 marks 
   

3. Compute the earnings after taxes for years 1 through 8 – 2 marks

4. Compute the OCF for years 1 through 8 – 2 marks

5. Compute the Terminal cash flow – 1 mark 

6. Compute the FCF for years 1 through 8 – 2 marks

7. Compute the NPV and IRR – 3 marks

8. Should the project be accepted? – 1 mark