The directors of AAP company limited has decided to limit investment funds to $1
ID: 2806061 • Letter: T
Question
The directors of AAP company limited has decided to limit investment funds to $10 million for the next year and is preparing its capital budget. The company is considering five projects, as follows: Initial investment Net present value Project A $2,500,000 $1,000,000 Project B $2,200,000 $1,550,000 Project C $2,600,000 $1,350,000 Project D $1,900,000 $1,500,000 Project E $5,000,000 To be calculated All five projects have a project life of four years. Projects A, B, C and D are divisible, and Projects B and D are mutually exclusive. All net present values are in nominal, after-tax terms. Project E This is a strategically important project which the Board of AAP Co have decided must be undertaken in order for the company to remain competitive, regardless of its financial acceptability. Information relating to the future cash flows of this project is as follows: Year 1 2 3 4 Sales volume (units) 12,000 13,000 10,000 10,000 Selling price ($/unit) 450 475 500 570 Variable cost ($/unit) 260 280 295 320 Fixed costs ($000) 750 750 750 750 These forecasts are before taking account of selling price inflation of 5•0% per year, variable cost inflation of 6•0% per year and fixed cost inflation of 3•5% per year. The fixed costs are incremental fixed costs which are associated with Project E. At the end of four years, machinery from the project will be sold for scrap with a value of $400,000. AAP Co has a nominal after-tax cost of capital of 13% per year. Required: a) Evaluate the financial acceptability of project E using: i. a nominal terms net present value approach ii. an internal rate of returns approach b) Calculate the maximum net present value which can be obtained from investing the fund of $10 million, assuming here that the nominal after-tax NPV of Project E is zero.
Explanation / Answer
Part i: Evaluate the financial acceptability of project E using: i. a nominal terms net present value approach ii. an internal rate of returns approach Sol *Figures in Millions Calculation of NPV year 1 2 3 4 5 Sales Income 5670 6808 5788 6928 Variable Cost -3307 -4090 -3514 -4040 Contributions 2363 2718 2274 2888 Fixed Cost -776 -803 -832 -861 Cash Flow 1587 1915 1442 2027 Scrap Value 400 Net Cash flow 1587 1915 1442 2427 Discount at 13% 0.885 0.783 0.693 0.613 Present Value 1404 1499 999 1488 Sum of PV 5391 Intial Investment 5000 NPV 391 Answer As the result is positive so it is financially acceptable Working: year 1 2 3 4 Selling price per unit 450 475 500 570 Inflated Selling price per unit (selling price *(1+5%)) 472.50 523.69 578.81 692.84 Sales Volume (units) 12000 13000 10000 10000 Sales Income 5670 6808 5788 6928 Variable Cost per unit 260 280 295 320 Inflated Variable Cost per unit 275.60 314.61 351.35 403.99 Sales Volume (units) 12000 13000 10000 10000 Variable Cost 3307 4090 3513 4040 Part b) Calculate the maximum net present value which can be obtained from investing the fund of $10 million, assuming here that the nominal after-tax NPV of Project E is zero. *Figures in Millions Sol: Project A B C D E Investment 2500 2200 2600 1900 5000 NPV 1000 1550 1350 1500 0 PV of future Cash flows 3500 3750 3950 3400 5000 Profitability Index 1.40 1.70 1.52 1.79 1.00 Ranking 4 3 2 1 Project (rank wise) Investment NPV Project E 5000 0 Project D 1900 1500 Project C 2600 1350 Project A* 500 200 10000 3050 (Answer) As Project A is divisible and only $500,000 (20%) of its $2,500,000 initial cost is available after cumulative investment in Projects E, D and C, the NPV from the project is $200,000 (20% of $1,000,000). "Please let me know for further clarifications"