Reference no: EM132745775

Question: Melbourne Clouds Ltd.'s (Microphone manufacturing and selling company), CFO, Mr. Michael has been asked by CEO, Mr. Ken, to assist with an investment appraisal. They have recently completed a three-year feasibility study on whether, or not, to expand their market offerings and offer specially designed high-quality microphone for customers and invest on capital infrastructure for the production line. The market research indicates no other competitors have ever sold this specially designed product before. It might open a completely new market for Clouds Ltd. In addition, it was revealed that this specially designed high-quality microphone can be sold via (e-trade) on-line trading system.

Clouds Ltd. is considering a proposal to acquire new machineries (which has an expected useful life of 6 years). If the company decides to purchase the new machineries, it will receive $ 500,000 for the existing machines in the year 1. The existing machineries had been fully depreciated and net book value of the assets is Zero. The new equipment will be placed in service on 1 January 2021. The details regarding the proposal are as follows:

• Expected cost of the new machineries is $ 2,955,000

• Expected installation costs of the new machineries is $ 45,000.

• Expected increase in working capital at the beginning of operations $ 72,000 and expected working capital at the end of the project $ 58,000.

• Expected investment allowance (tax free due to Covid-19 crisis) received from the government to support manufactures (at the end of year 2) is 15% of total amount of capital invested (excluding working capital investment).

• Expected terminal value at the end of year 6 is $150,000.

• Expected repairs to maintain production efficiency (end of year 3): $ 87,000.

• Working capital will be released at the end of year 6.

• Expected increase in annual cash revenue $760,000

• Expected increase in annual cash operating expenses $ 174,000

• It is assumed that all cash flows occur at the end of each year.

• The taxation depreciation on the equipment would be 16.67% straight line.

• The company is subject to a 30% tax rate and has an after-tax required rate of return of 12%.

Required: (a) What type of investment is Clouds Ltd making? Provide details as to why you came to this conclusion and other considerations in making the investment decision.

(b) Calculate the Net Present Value (NPV) of the proposed investment after tax.

(c) Advise Clouds Ltd management whether they should proceed with the project.