Reference no: EM132535939

Olourun Ltd is the major employer in the Front Hill area, where the firm is located. The company is considering the acquisition of a new production line. The equipment would cost $720 000 and installation cost would amount to $59 000. At the end of its 5-year life, it is expected to be disposed of at its salvage value of $70 000. The new equipment would allow the company to expand production significantly, which would require an increase in working capital of $90 000. If the purchase is made, the firm's maintenance costs would be reduced by $60 000 annually. However, at the end of the third year, a major overhaul would have to be undertaken at a cost of $80 000. Operating cash flows would be $220 000 in the first year; this would increase by 2% for of the following years.

The company's cost of capital is 14% and the relevant corporate tax rate is 25%

Question a) Calculate the relevant after-tax net cash flows and after-tax profits over the life of the investment.

Question b) Compute the project's ARR

Question c) What is the payback period?

Question d) Using the NPV as the basis of your decision, advise Olourun as to whether the company should purchase the equipment.

Question e) Would you advise the company to base their decision on the payback method rather than the NPV as used above?

Question f) Compute the IRR of the project

Question g) The company is considering another investment would have an initial cost of $800 000 and an NPV of $65000. There is a situation of capital rationing, and you have suggested that the firm should use the profitability index to choose which investment to implement. Advise the company.

Question h) Discuss THREE non-financial factors which the firm should consider when making this decision.

Question i) Why is it important for the company to know its cost of capital when making investment decisions?