Reference no: EM133103412
Question - Sussex Industries (SI) is considering a new capital budgeting project that will last for three years. SI will need a new production line for the project. The upfront cost of setting up the production line is £90,000, which will be depreciated over 3 years (until Year 3) on a straight-line basis. Assume there will be no salvage value for the production line. If the company decides to launch the project, it will have to incur the cost of £20,000 to establish an after-sales customer service strategy. The two costs are to be incurred in Year 0. From Year 1 to Year 3, the predicted sales volume of the new product is 50,000, the predicted unit cost of production is £1 and the predicted price of each unit is £4. SI will also have to invest in working capital from Year 1, which will be fully recovered in Year 3. Predicted working capital balances are shown in the following table
|
|
Year 0
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Year 1
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Year 2
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Year 3
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Cash
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0
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4000
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5000
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0
|
|
Inventory
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0
|
2000
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1000
|
0
|
|
Accounts receivable
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0
|
2000
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1500
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0
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Accounts receivable
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0
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3000
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3500
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0
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In Year 2, the firm will be required to pay an additional fee of £4,000 to the local carbon emissions authorities. The corporate tax rate is 25% (assuming losses give rise to tax savings). Assume that cash flows arrive at the end of each year. The project will be financed by issuing new equity.
a. Using the information described above, calculate the free cash flow that will be generated by the project for each year from Year 0 to Year 3. Briefly explain each step of your calculation.
Suppose that a comparable public firm in the same industry as the Sussex Industries (SI) has a beta of 1.5. The market risk premium is 8% and the risk-free interest rate is 4%. Using the information from Part a, calculate the net present value (NPV) of the SI's new project. Would you recommend investing in the project?