- 14 Marks
MA – Nov 2018 – L2 – Q1a – Discounted Cash Flow
Assess the financial desirability of producing designer ceramic tiles by calculating the net present value in real terms.
Question
Mawuena Ltd, a manufacturer of building materials, has recently suffered falling demand due to economic recession, and thus has unutilised capacity. Management has identified an opportunity to produce designer ceramic tiles for the home improvement market. It has already paid GH¢1.5 million for development expenditure, market research, and feasibility studies.
A new machine, with a useful life of four years, could be bought at GH¢6.5 million, payable immediately. The scrap value of the machine is expected to be 5% of the cost, recoverable a year after the end of the project.
The research and development division has prepared the following demand forecast:
| Year | 1 | 2 | 3 | 4 |
|---|---|---|---|---|
| Demand (units) | 110,000 | 130,000 | 150,000 | 145,000 |
The selling price is GH¢50 per box (at today’s price). Estimated operating costs, largely based on experience, are as follows:
| Cost per box of tiles (at today’s price) | GH¢ |
|---|---|
| Materials cost | 12.00 |
| Direct labour | 5.00 |
| Variable overhead | 2.50 |
| Fixed overhead (allocated) | 3.50 |
| Distribution (Variable) | 5.50 |
In addition to the initial cost of machinery, investment in working capital of GH¢0.2 million will be required in year two. Mawuena Ltd pays tax one year in arrears at an annual rate of 30% on returns from the project. Mawuena Ltd shareholders require a nominal return of 14% per annum after tax, which includes allowance for generally expected inflation of 5.55% per annum. (Ignore Capital Allowance).
Required:
Assess the financial desirability of this venture in real terms, computing the net present value offered by the project. (14 marks)
Find Related Questions by Tags, levels, etc.
- Tags: Capital Budgeting, Net Present Value, real terms analysis, scrap value, Tax implications
- Level: Level 2
- Topic: Discounted cash flow
- Series: NOV 2018