Reference no: EM132662070

Question 1

Consider the following investment appraisal project:

Brady Plc is considering an investment appraisal project about which the following information is available:

1. The investment outlay on the project will be $100m. This consists of $80m on plant & machinery and $20m on net working capital. The entire outlay will be incurred at the beginning of the project.
2. The project is expected to lead to a revenue of $60m in the first year, expected to increase at 5% each year for the next 5 years. Expected costs in the first year are $20m for material, $10m as employee related expenses, and $5m as other expenses. The costs may be considered to inflate at 3%.
3. Considerable amount of R&D has been done to decide whether to go ahead with the project. Expenses to the tune of $10m have already been incurred.
4. Plant and machinery will be depreciated at the rate of 25% per year as per written down value method. Effective tax rate is 30%.
5. The life of the project is expected to be 5 years. At the end of 5 years, fixed assets will fetch a net salvage value based on the final depreciated value of the plant & machinery, and the net working capital will be liquidated at its book value.
6. The project will be financed with $45m of equity capital, $5m of preference capital, and $50m of debt capital. Assume the cost of capital of the project is 8%.

Answer the following questions related to the above project:

a. Highlight the costs associated in the project. While some of these costs are relevant to the project, some are irrelevant. Divide the costs identified above into these two broad categories - relevant and irrelevant costs.

b. In order to make an investment decision for the above project, should we use cash flows or profits? Mention your reasons highlighting the differences between the two?

c. The project is financed with both debt and equity. The debt will carry an interest which the firm will have to bear each year for the life of the project. Should we include the interest in the operating cash flow computations? Why or why not?

d. Investment appraisal forecasts need to keep in mind 'inflation' in the revenues and costs. Why is it so?

e. While we can compute the NPV of the project and decide whether to go ahead with the project or not based on the value of NPV, it is considered to be better to look at projects as 'options' rather than a simple yes/no decision. That way, the manager can delay the execution and keep the option alive. Do you think looking at projects as options help the managers in any way? While considering projects as options, in what ways does the NPV computation of the project differ from the original method of computing NPV?