Managerial Finance Task: Project Evaluation

Question 1

Project evaluation is a crucial element in investment decisions made by firms. The Australian manufacturer, Dukeview Corporation Limited (DCL) is assessing a new contract opportunity.

The proposed cash flows for the contract being considered are:

Year 1 $1.040m
Year 2 $0.600m
Year 3 $0.965m
Year 4 $0.550m
Year 5 $0.700m
(NB, all cash flows are shown before loan payments and interest.)

Accepting the contract will require DCL to invest in new equipment at a total cost of $2.4m, all of which must be paid upfront. DCL does not have enough cash on hand to meet this cost and has arranged an ‘approval-in-principle' with their bankers for 50% of the total investment amount. The contract is for a term of 5 years and the loan term will match this and be repaid in full over that term with equal, annual instalment paid on the last day of each year. The loan will be at a fixed rate of 5.70% pa, which compares favourably to DCL's cost of capital and required rate of return of 12.5%.

The new equipment has a useful life to match the contract term, is to be depreciated at 40%pa on a diminishing value basis and will have a salvage value of 10% of its initial cost.

DCL has a policy of having their capital on any investment returned in no more than 2.5 years.

The Board of DCL have asked you to evaluate the project and advise whether it should be accepted or rejected.

You are required to calculate the project's:

(1) NPV

(2) IRR (% to two decimal places)

(3) Payback period, the payback (in years to two decimal place)

(4) ARR (to two decimal places)

(5) PI (Present value index/Profitability index) (to two decimal places)

(6) Based on the above, you must make recommendations as to the acceptability or otherwise of this project? The DCL Board requires your recommendation to include a decision and explanation for each of the methods in parts (1) to (5) and then provide an overall recommendation for their consideration. Whether they should or should not accept the contract and why or why not (provide a full explanation)? The Board has also asked that you briefly explain of your treatment of Salvage Value and Loan Repayments in your analysis. (Your written explanation must not exceed 750 words).

Question 2

Project evaluation is a crucial element in investment decisions made by firms, but is one evaluation enough? Can the future be forecast accurately enough that only one set of numbers need be assessed?

Curtis Industries Limited (CIL) is a mining services contractor operating in the Bowen Basin in Central Queensland. CIL is considering a new project that will require the purchase of a piece of new equipment costing $10,700,000. The equipment will be involved in heavy manufacturing work that will see its useful life only be four years and the project will not extend past this time. The manufactured product, a new type of valve, is expected to be in high demand as it provides significant cost savings to the industry due to its long-lasting nature. In four years, it is expected the market will be saturated and the sales rate will drop dramatically, thus CIL will cease manufacturing at that time.

The Federal Government's Industry Investment Scheme is offering a 15% rebate to CIL on the initial investment amount.

The project will require additional administrative staff and other costs totalling $289,000 per annum, rising with inflation.

Additional Information
1. Valve sales price per unit: $99.

2. Projected sales in year 1 are 143,000 valves, withtotal sales revenue rising annually thereafter at the economic growth rate.

3. At the end of the project theequipment will be sold for 12.5% of its initial, total value.

4. Connor Reed Capital, an investment bank specialising in the mining sector, undertook a feasibility study six months ago at a cost of $750,000. The study recommended the project proceed and the figures in this summary are drawn from that report.

5. The machinery is considered depreciable for tax purposes and will be depreciated using a diminishing value method, which is equal to twice the annual straight-line rate.

6. An initial injection of $420,000 working capital is required to fund the first three years of the project and in year three, it is forecast that an additional 50% of that amount will be required. Whilst the year three injection is not certain it is included in the forecasts.

7. CIL corporate policy requires the assignment of Head Office expenses across operating divisions. A fixed allocation of $250,000 per year will be charged to this project even though it will cause no increase in Head Office expenses.

8. All financial forecasts see the cash operating expensesfor the valve project at 63% of sales revenue.

9. Given CIL's status as a mining services contractor and this valve project being their first foray into manufacturing, the project has been deemednot to be in line with the CIL's core business and is considered to carry a of a higher risk. because of this.Connor Reed Capitalhas calculated the real required rate of return on a higher risk project such as this to be 10.16% (after tax).

10. RBA forecasts for the four-year outlook are for an inflation rate of 2.7% and an economic growth rate of 3.3%, both on a per annum basis.

11. Despite Government attempts to reduce it, the company tax rate is expected to remain at 30% and tax is paid in the year after the income is earned.

12. Assume all cash flows are in Nominal values, unless otherwise stated AND except for initial outlays, assume cash flows occur at the end of each year (unless otherwise stated).

CIL has engaged you as a consultant and asked you to:

(1) Calculate the NPV, advise if the project is acceptable and explain why or why not?
(2) CIL is particularly concerned about the accuracy of the forecast and requires you to conduct a sensitivity analysis showing how sensitive the project is to sales revenueand to the cost of capital. You must explain your results.
(3) In order to help CIL understand the position, explain to them from a theoretical perspective, what additional insight can Scenario analysis give, that sensitivity analysis cannot? (You may use numbers to illustrate your answer but you do not have to).
(4) To give comfort to CIL, explain how risk has been priced into this project and explain the extent to which management may be confident the return on investment is in accordance to its risk.