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 $1.75 million. The machine has an estimated life of three years for accounting and taxation purposes. Installation will cost a further $115,000. The contract will not continue beyond three years and the equipment’s estimated salvage value at the end of three years is $280,000. The tax rate is 27 percent and is payable in the year following the year in which profit is earned. An investment allowance of twenty percent on the outlay plus installation costs is available. The after tax cost of capital is 14.25%pa. Addition current assets of $96,000 are required immediately for working capital to support the project. Assume that this amount less $10000 is recovered in full at the end of the three-year life of the project. The new product will be charged $149,500 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 $198,000 per year, will be incurred by the Steel Division for the project. An amount of $149,000 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 in the first year for the new product are 40,000 units at $142 per unit per year. Unit sales are expected to increase by 5%pa for year two and three. Cash operating expenses are estimated to be 82 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.
(a) Construct a table showing net cash flow after tax (NCFAT). Use the method shown in lectures.
(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 and to the cost of capital. Explain your results.
(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).