- 15 Marks
FM – L2 – Q21 – Discounted cash flow
Question
Tema Electrical Plc is considering whether to purchase a machine for the manufacture of a new product, Product X. It has been estimated that Product X would have a life of four years and at a selling price of GH¢8 per unit, annual sales demand would be 400,000 units in Year 1, 600,000 units in Year 2 and 800,000 in each of Years 3 and 4.
Variable production and selling costs would be GH¢6 per unit. Incremental annual fixed cost expenditures (all cash cost items) would be GH¢500,000 in Year 1, rising by GH¢20,000 each year.
The machine, which has an annual output capacity of 700,000 units of Product X, would cost GH¢1,200,000 and would have a resale value of GH¢200,000 at the end of Year 4. Capital allowances would be available on a 25% annual reducing balance basis, with a balancing charge or allowance in the year of disposal. Tax at 25% is payable one year in arrears of the profits to which it relates.
Tema Electrical Plc is financed 70% by equity capital and 30% by debt capital. The equity has a cost of 10% and the debt has a cost of 8.9% (before tax).
Required
Calculate the net present value of the proposed project and recommend whether the investment in the machine should be undertaken.
Answer
Workings
WACC
(WACC = (70% × 10%) + [(30%) × (8.9%)(1-0.25)] = 7% + 2% = 9%.
Capital allowances
Year Tax WDV Capital allowance Tax saved at 25%
1 1,200 900 300 75
2 675 225 56.25
3 506.25 168.75 42.188
4 200 306.25 76.563
Project cash flows
Year 1 Year 2 Year 3 Year 4
GH¢ GH¢ GH¢ GH¢
Sales revenue 3,200,000 4,800,000 6,400,000 6,400,000
Variable costs (2,400,000) (3,600,000) (4,800,000) (4,800,000)
Fixed costs (500,000) (520,000) (540,000) (560,000)
Cash profits 300,000 680,000 1,060,000 1,040,000
Tax benefit of cap. allowances 75,000 56,250 42,188 76,563
Disposal of machine 200,000
Tax on profits (25%) (75,000) (170,000) (265,000)
Net cash flow 375,000 661,250 932,188 1,051,563
NPV calculation
Year Net cash flow Discount factor at 9% Present value
0 (1,200,000) 1.000 (1,200,000)
1 375,000 0.917 343,875
2 661,250 0.842 556,773
3 932,188 0.772 719,649
4 1,051,563 0.708 744,507
NPV 772,819
Recommendation
The NPV of the project is + GH¢772,819.
The project would appear to provide a DCF return well in excess of the WACC and on financial considerations (assuming that the estimates of costs and revenues are reasonably reliable) the project should be undertaken.
- Topic: Discounted cash flow
- Uploader: Samuel Duah