Reference no: EM132979166

Question - Happy Birds plc is considering investing into a new 5-year project after a feasibility research that cost the company £50,000 last month. Based on the research, the project is estimated to generate £600,000 in annual sales with costs of goods sold of £200,000. In addition to this variable cost, there are relevant general & administration expenses of £20,000 each year for the project. This project requires an initial capital spending on a machine that costs £1 million immediately and the company's accounting department suggests that it is appropriate to depreciate this machine in a straight line over its five-year life to a zero salvage value for accounting and tax purpose. £25,000 working capital is required at the beginning of the project and the full amount of working capital will be recovered when the project terminates. Given the risk of the project, the appropriate cost of capital is 15% and the company pays a corporate income tax of 40%.

REQUIRED -

i. What are the project's free cash flows?

ii. Calculate the NPV of this new project and briefly explain the implications of the NPV calculated for the firm's shareholders.

- Briefly discuss any potential drawbacks to the NPV method.

- Calculate the payback period of this new project.

- Briefly discuss any potential shortcomings of the payback period rule.