Huawii Co is appraising an investment project which has an expected life of four years and will not be repeated in the future. The equipment required by the project is already owned by the company. It originally cost £1.5m while the current book value is £1m and is estimated to be sold for £0.4m at the end of Year Four. Once the project starts, the equipment cannot be used for other purposes.
For the past few years, Huawii has invested heavily in Research and Development – 10% of net profit every year approximately. The amount related to the new project is valued as £0.8m, which includes £0.2m to be paid in Year One only if the project runs. If the company decides against undertaking the project, the technique developed would be sold as a patent to another company for £2.4m immediately. The company also hired an independent consultant company for £50,000 to investigate market potential of the project which has already been paid. According to the market research report submitted, the project could generate:
Y1 Y2 Y3 Y4 Sales £2.5m £3.2m £6.4m £6.8m
Overheads £0.2m £0.4m £0.8m £0.8m
Marketing expenses £0.3m £0.2m £0.1m £0.1m
Interest charges@8% £0.2m £0.2m £0.2m £0.2m
Moreover, direct labour will cost 30% of sales which includes additional workers that have to be recruited by the project. At the end of the project it is unlikely they could be offered further work and redundancy costs of £0.1m are expected. Direct materials will be 20% of sales. Additional £0.8m of working capital from the beginning of the project is required.
Finally, the company adopts the straight-line method for depreciation and has a cost of capital (WACC) of 10%.
Ignoring inflation and taxation, you are required to address the following:
(a) Explain the concept of ‘relevant cash flows’ for investment decisions and apply the criteria to the case of Huawii Co – you need to prepare a table of relevant cash flows for this project.
(20 marks)
(b) Calculate PBP (Payback period), IRR (Internal rate of return) and NPV (Net Present Value) of the project. State, giving reason(s), whether the project should be accepted.
(30 marks)
(c) Cash flows have been applied to assess the investment project so far. Explain why accounting profits may not be the best measure of a company’s achievements.
(20 marks)
(d) Discuss the effect of a substantial rise in interest rates on the investment decision-making process for businesses.