Reference no: EM132593249

Assume that you have been appointed finance director of O.K. Ltd. The company is considering investing in the production of electrical products, with an expected life of three years. The data related to the project are given below:

(1) The machinery and equipment for the project cost $6 million, to be paid in two installments, 60% of the invoice to be paid now and the remaining will be paid in a year.

(2) The depreciation allowance is calculated on a straight-line basis on the cost $6 million.

(3) The required investment in net operating working capital at the beginning of the project is $400,000 which can be recovered at the end of the project.

(4) Production and units sold during the 3 years of the project life is expected to be as follows: 30,000 units in year one, 36,000 units in year two, and 44,000 units in year three.

(5) The selling price is expected to be $180 in the first year and increase at 10% per year.

(6) The variable operation costs per unit for the first year is $100 and will increase at 8% per year.

(7) The fixed cost (excluding depreciation) is expected to be $400,000 for the first year and will increase by the amount of $100,000 per year.

(8) The machinery and equipment can be disposed at the end of the project for $1 million.

(9) The profit tax rate is 20% and the cost of capital is estimated to be 15%.

Required:

Question a. Determine the project's free cash flows.

Question b. Calculate the NPV and payback for the project. Suppose the company has a policy that it will not accept project with payback more than 2 years. Will the project be accepted? Discuss the major limitations of the payback method in capital budgeting decision.

Question c. Calculate the sensitivity of the NPV to a change in the selling price and to a change in the fixed cost. Assume the selling price decreases by 10% and the fixed cost increases by 10%. Comment on your findings.