Problem 1: Polycorp is considering an investment in new plant of $3.1 million. The project will be financed with a loan of $2,000,000 which will be repaid over the next five years in equal annual end of year instalments at a rate of 6.5 percent pa. Assume straight-line depreciation over a five-year life, and no taxes. The projects cash flows before loan repayments and interest are shown in the table below. Cost of capital is 12.15% pa (the required rate of return on the project). A salvage value of $255,000 is expected at the end of year five and is included in the cash flows for year five below. Ignore taxes and inflation.
Year Cash Inflow
Year One 880,000
Year Two 860,000
Year Three 810,000
Year Four 910,000
Year Five 945,000
You are required to calculate:
(1) The amount of the annual loan repayment and produce a repayment schedule.
(2) NPV of the project (to the nearest dollar)
(3) IRR of the project (as a percentage to two decimal places)
(4) AE, the annual equivalent for the project(AE or EAV) (to the nearest dollar)
(5) PB, the payback and discounted payback in years (to one decimal place)
(6) ARR, the accounting rate of return (gross and net) (to two decimal places)
(7) PI (present value index or profitability index) (to two decimal places)
(8) Is the project acceptable? You must provide a decision or explanation for each of the methods in parts (2) to (7). Why or why not (provide a full explanation)? Also a brief explanation of your treatment of Salvage Value and Loan Repayments is required.
Problem 2: Calculations must be done in Excel
Polycorp Limited Steel Division is considering a proposal to purchase a new machine to manufacture a new product for a potential three year contract. The new machine will cost $1.5 million. The machine has an estimated life of three years for accounting and taxation purposes. The contract will not continue beyond three years and the equipment's estimated salvage value at the end of three years is $128,000. The tax rate is 29 percent and is payable in the year in which profit is earned. An investment allowance of twenty five percent on the outlay is available. The after tax cost of capital is 12.85%pa. Addition net working capital of $72,000 is required immediately for current assets to support the project. Assume that this amount is recovered in full at the end of the three year life of the project. The new product will be charged $59,500 of allocated head office administration costs each year even though head office will not actually incur any extra costs to manage the project. This is in accordance with the firm's policy of allocating all corporate overhead costs to divisions. Extra marketing and administration cash outflows of $68,500 per year will be incurred by the Steel Division for the project. An amount of $159,000 has been spent on a pilot study and market research for the new product. The projections provided here are based on this work. Projected sales for the new product are 32,000 units at $133 per unit per year. Cash operating expenses are estimated to be 75 percent of sales (excludes marketing and administration, and head office items). Except for initial outlays, assume cash flows occur at the end of each year (unless otherwise stated). Assume diminishing value depreciation for tax purposes.
Required
(a) Construct a table showing your calculations of net cash flow after tax (NCFAT). Use the method shown in lectures and notes.
(b) Calculate the NPV. Is the project acceptable? Why or why not?
(c) Conduct a sensitivity analysis showing how sensitive the project is to operating expenses. Explain.
(d) Write a short report explaining your calculation of relevant net cash flows after tax, justifying your selection of cash flows. Be sure to state clearly any assumptions made (implicit and explicit).