Reference no: EM133633420
ABB Co Capital Budget Memo
The Board of ABB Co 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 $5,000,000 To be calculated.
All five projects have a project life of four years. Projects A, B, C, and D are divisible, and Projects B and D are mutually exclusive. All net present values are in nominal, after-tax terms.
Project E
This is a strategically important project that the Board of ABB Co has decided must be undertaken for the company to remain competitive, regardless of its financial acceptability. Information relating to the future cash flows of this project is as follows:
Year 1 2 3 4
Sales volume (units) 12,650 12,100 10,000 10,000
Selling price ($/unit) 440 475 500 570
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.
The initial investment cost of Project E is in CCA class 44 (25% deduction). ABB applies the maximum deprecation based on the CCA class. The project will be sold at book value in the final year of operation. ABB Co pays a corporation tax of 28% per year, one year in arrears.
ABB Co has a nominal after-tax cost of capital of 13% per year.
Required:
(a) Calculate the nominal after-tax net present value of Project E and comment on the financial acceptability of this project.
(b) Calculate the maximum net present value obtained from investing the fund of $10 million, assuming that the nominal after-tax NPV of Project E is zero.
(c) Discuss why the Board of ABB Co may have decided to limit investment funds for the next year.