Calculate the Net Present Value of the Investment

XYZ Ltd is a manufacturer of household goods located in Ang Mo Ko. They presently make and wholesale fruit juicers, blenders and baking equipment. The General Manager has asked that the company now consider investing in new equipment that will allow the company to make bench-top grills.

A former manager of a WhiteDecker electrical appliance store established XYZ Ltd in late 1990s and the growth of the company has been steady with total sales totalling SGD9,000,000 for the 2009-10 financial year. The net profit for the period was SGD1,200,000.

The company has already spent SGD60,000 on researching the bench-top grill investment project and another SGD15,000 reviewing the training needs of staff who will be using the new equipment. The special equipment needed to manufacture the grills and can be purchased from the United States for US$560,000. Given the current exchange rates, the equipment would cost SGD585,000 and a further SGD30,000 to complete installation. The equipment would be expected to have a five-year useful life for the firm.

The perception in the Singapore market on Singaporean made electrical products would require the company to spend SGD150,000 on marketing as soon as the project is approved by the board. A further SGD65,000 is required to rejuvenate the sale momentum. The campaign will be visible throughout the whole of third year but this expense can be paid upfront at the end of the third year. The General Manager also believes that a working capital injection of SGD70,000 would be required, but it is anticipated that the entire working capital could be recouped at the end of the project. The machining equipment can be fully depreciated at 20% of the total cost over the five years for taxation purposes.

A major service of the machine costing SGD200,000 would be required at in year 3. A software update required at the beginning of the same period is expected to cost SGD40,000. The service would occur over the Chinese New Year shut down period and is not expected to have any substantial impact on production. Both the service and software will ensure the machine is keeping up with the depreciation schedule needed to ensure the equipment remains productive until the end of year 5. A quick check with the company account and it is confirmed that these are tax deductible expense permitted by the tax office.

The average selling price is expected to be SGD50 and it is estimated that variable costs would be SGD35 per unit and fixed costs (not including depreciation) would amount to SGD70,000 per year.

The following unit sales are forecast:

Year 1 30,000

Year 2 30,000

Year 3 40,000

Year 4 40,000

Year 5 50,000  

The company's tax rate is 25%, and the finance director believes a 17.25% return is the minimum return required to satisfy all the stakeholders of the company. After discussions with other staff members, the accountant has come to the conclusion that the machine is likely to have a resale value of SGD30,000 at the end of the five years.

Required:

(a) Calculate, showing all workings:

i. The net present value of the investment.

ii. The undiscounted and discounted payback period of the investment.

iii. The internal rate of return of the project to two decimal places.

iv. The profitability index for the investment.

Part 2

(a) What is the effect on the NPV for the project if:

i) The company wishes to investigate option of not spending $50,000 marketing expense in the 3rd year but instead giving a sales discount of 12%. (i.e. just for the year). As a result sale figure is expected to decreased by 5% for both year 3 and 4(from the initial estimates), but an increase of 10% in year 5.

ii) The board is not convinced with your study and would like to order another independent study. The study is estimated to cost $7500.