Reference no: EM132894034

As the project investment manager at Turkish Airlines, you have been asked to evaluate the following proposal for a project which has an expected life of five years.

• A pilot study has recently been completed at a cost of $100,000. 50% of this cost has already been paid and the balance is now due.
• The pilot study has established that to invest in the project will require a capital investment of $5,200,000 for equipment. 40% of this expenditure will be required immediately with the balance payable at the end of year 1. In addition, an investment in working capital is needed. The initial investment will be $500,000 and this will grow to $800,000 at the end of year 1 and to $1,000,000 at the end of year 2. At the end of the project's life, it is expected that the whole of the working capital will be recovered and that the equipment will have a scrap value of $600,000.
• Revenues from the project are estimated to be $2,500,000 for the first year and will then grow by 5% per year for the remainder of the project's life. Direct costs will be $1,200,000 in the first year and then grow by 7% per year thereafter. In addition, the project will be charged by head office each year with an allocation of company overheads equivalent to 15% of the revenues of the year concerned.
• For the first three years of the project, Turkish Airlines will require a return of 10% per year. From year four the required return will increase to 12% per year.
• You should assume that, with the exception of the initial investment in equipment and working capital and the balance of the pilot study costs, all cash flows arise at the end of the year concerned.

Required:

Problem a) Provide thorough calculations to determine whether or not the project should be accepted.

Problem b) There is uncertainty as to the scrap value of the equipment given above. By how much should the scrap value need to change for Turkish Airlines to be indifferent between accepting and rejecting the project?