Pump Limited is a company based at Windhoek. The company produces various consumer products and is presently considering the introduction of a new product line. Pump Ltd currently has a total valued at N$50 million. Net income before tax from the existing continuing operations is N$10 million. This level of income shall not be affected by the introduction of the new product line.
The new product line would require investment in plant and machinery amounting to N$10 Million. The company would be required to invest another N$6.25 million in working capital now and a further N$1.05 in working capital in a year’s time. The new product line is expected to result in low sales in the initial two years, but sales are expected to be high in Years 3, 4, 5, and 6. Demand for the product is expected to last for six years. The residual value of the plant and equipment is at the end of Year 6 is expected to be N$2 million and the investment in working capital of N$7.3 million will be recovered at that time.
Low sales in the first two years and the costs incurred in promoting the new product will result in an operating loss before depreciation in the first year of N$17 million. The incremental operating cash flows from the project are expected to be as follows:
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Operating cash flows (‘000’)
(17 000)
1 000
18 000
24 000
18 000
18 000
In the budget speech presented by the Hon. Amadhila (Minister of Finance), it was revealed that the company tax rate shall change from the current 30% to 28% and according to the same budget the receiver shall allow depreciation deduction of 40% of cost in the first year and 20% of cost in the three subsequent years. The company expects that these tax proposals shall be enacted before the commencement of the project.
The company’s depreciation policy is 20% per annum straight line method while the cost of capital (WACC) is 14%.
Required:
1. (a) Calculate the net present value of this project. Your answer should include clear workings of the project’s cash flows.
(b) Assume you are the finance manager at Pump Ltd and that the company is a subsidiary of Still Holdings. Your performance is appraised on the basis of this new product line. Explain how your decision to invest in this project would be affected if your director has indicated that you shall be transferred to Walvis Bay where the head office of Still is, two years from now.
2. Conflict of interest is inherent in most management decisions. Explain any two ways of reducing this conflict of interest in an organisation.