Reference no: EM133031073

Question - Management are considering a project to buy and operate a major item of equipment. Your boss is extremely enthusiastic about the project, arguing that (i) it has a very high rate of return and acceptable payback period, and (ii) it will definitely add to shareholder value. The equipment costs $385,000, is anticipated to be sold at the end of year 5 for $20,000, and will be depreciated straight line over the five-year period. The equipment will be used to manufacture a new type of electrical switch which will be sold at a price of $2.50 per unit. Expenses associated with this project other than depreciation can be assumed to be 51% of the sales revenue. The relevant discount rate is 12.5% and can be assumed to be the hurdle rate for both the accounting rate of return and the internal rate.

Year Sales (units)

1 58,000

2 72,000

3 86,000

4 100,000

5 114,000

1) Prepare a table of cash flows, discount factors and present values as relevant for calculation of the net present value (NPV), and calculate the project's NPV.

2) Calculate the project's internal rate of return (IRR), and show your answer as a percentage with 2 decimal laces (e.g. 12.34%).

3) Assume that customers take one month to pay, the project requires inventory of $15,000 to be held, that accounts payable attributable to the project has a permanent balance of $10,000, and that working capital requirements are in place at the start of each year. Prepare a table to show the effect of these considerations on the project's cash flows.

4) Comment, in general terms, about how working capital requirements affect the cash flows and the NPV of the project.

5) Based on your analysis, what are your recommendations regarding this project? Do you agree with the comments made by your boss? Why or why not?