Financial management

Illustrative problem for investment decision

The case of Expansion project: this is in addition to class illustration

Kombolcha enterprise produces leather jackets, bags, wallets and belts. Eighty percent of its products are exported while 20% of each product is currently sold in the domestic market. The Enterprise plans to expand its domestic market by introducing a new product line. The expansion plan involves introducing a new product in addition to its existing ranges of leather products. Itis proposed to introduce synthetic leather (imitation) bags which are assumed to add to profitability of the enterprise. Input materials for the product are locally available. Skills and experiences gained in producing the pure leather bags is expected to benefit the product design and manufacturing process, thus, training costs will not be incurred.

Kombolcha needs to import a processing machine for this venture. The new processing machine will be used to perform multiple functions including embroidering of different decorative marks on the materials, cutting and sewing into different sizes of bags. The packing process will be accomplished manually. Acquisition of the machine is therefore the required main investment to introduce the new product. Management of Kombolcha wants to go into the business by introducing first at smaller scale and gradually move to aggressive expansion if the product is profitable.

The acquisition cost of the new machine is birr 200,000. The machine will be transported to the plant premises at a cost of Birr 10,000. Installation and testing of the machine (construction of plat form, installation, test running of production using materials and labor cost) is estimated at birr 30,000. The machine has economic life of 4 years with the estimated salvage value of birr 25,000.The tax law, however, permits that the following depreciation schedule be applied.

                                First year                                            33%

                                Second year                                       45%

                                Third year                                          15%

                                Fourth year                                          7%

                                                                                          100%

In addition to the acquisition cost of the machine the enterprise has to provide for working capital necessary for the production of the new product. This is necessary to acquire input materials, supplies and pay wages. This amount is equal to 15% fort year sales. Expected total number of units produced and sold are 1, 500 units per year. Unit selling price is birr 200, and unit production cost birr 100. The selling price and unit cash cost of production is expected to increase at the rate of 3% at the end of each year after the first year. The enterprise pays 40% income tax on its profit. We assume all sales are collected in the same year.

Kombolcha enterprise finances its operation from combination of Debt, preferred stock and common equity. Its capital structure and costs are as follows:

Source                            weight                                                  cost before tax                

Debt                               30%                  (interest)                            10%                    

Preferred stock               10%                 (dividend)                            10%

Common equity               60%                (required rate of return)      12%

The enterprise wants to maintain the same capital structure in its financing of any new project. Increase in costs of components is not expected for the next birr 500,000 additional funds to be raised. Thus, its WACC is 10%(1-.4)(.3)+10%(.1)+12(.6)= 10%.

Required:

I. Assumecontraction of the existing market for the enterprise's leather products is not anticipated as marketing of the synthetic leather is to target different segment of the market.

1. Compute the initial cost of the project
2. What is the depreciation base of the new machine?
3. Calculate annual depreciation for the four years on the basis of the schedule given above
4. Calculate the projected sales for the four years
5. Calculate the projected cost over the four years
6. Determine the additional working capital requirement
7. Determine the operating cash flows for the four years
8. Determine the terminal year cash flow in addition to operating cash flow
10. Determine the annual net cash flow for each year

Using the annual net cash flow determine
1. the project NPV
2. the IRR and MIRR
3. the project payback period, and
4. the PI
Do you recommend the project to be accepted?

II. Now assume that introducing the new imitation bags will have externality (cannibal) effect of reducing the sales of the leather bags by birr 50,000 (net) each year due to shifting of some customers to the new product. What will happen to the NPV, IRR, MIRR, and your decision?
(Recompute the figures first)

III. Explain the following from capital budgeting point of view

1. Sensitivity analysis

2. Scenario analysis

3. Externalities,

4. Positive externalities, and negative externalities,

5. Sunk cost

6. Incremental cash flow