190. Hraxin Co (June 15 – Amended)
Hraxin Co is appraising an investment project which has an expected life of four years and which will not be repeated. The initial investment, payable at the start of the first year of operation, is $5 million. Scrap value of $500,000 is expected to arise at the end of four years.
There is some uncertainty about what price can be charged for the units produced by the investment project, as this is expected to depend on the future state of the economy. The following forecast of selling prices and their probabilities has been prepared:
Future economic state |
Weak |
Medium |
Strong |
Probability of future economic state |
35% |
50% |
15% |
Selling price in current price terms |
$25 per unit |
$30 per unit |
$35 per unit |
These selling prices are expected to be subject to annual inflation of 4% per year, regardless of which economic state prevails in the future.
Forecast sales and production volumes, and total nominal variable costs, have already been forecast, as follows:
Year |
1 |
2 |
3 |
4 |
Sales and production (units) |
150,000 |
250,000 |
400,000 |
300,000 |
Nominal variable cost ($000 ) |
2,385 |
4,200 |
7,080 |
5,730 |
Incremental overheads of $400,000 per year in current price terms will arise as a result of undertaking the investment project. A large proportion of these overheads relate to energy costs which are expected to increase sharply in the future because of energy supply shortages, so overhead inflation of 10% per year is expected.
The initial investment will attract tax-allowable depreciation on a straight-line basis over the four-year project life. The rate of corporation tax is 30% and tax liabilities are paid in the year in which they arise. Hraxin Co has traditionally used a nominal after-tax discount rate of 11% per year for investment appraisal.
Required:
A. Calculate the expected net present value of the investment project and comment on its financial acceptability.
Calculation of expected net present value
|
1 |
2 |
3 |
4 |
|
$000 |
$000 |
$000 |
$000 |
Revenue |
4,524 |
7,843 |
13,048 |
10,179 |
Variable cost |
(2,385) |
(4,200) |
(7,080) |
(5,730) |
Contribution |
2,139 |
3,643 |
5,968 |
4,449 |
Overhead |
(440) |
(484) |
(532) |
(586) |
Cash flow before tax |
1,699 |
3,159 |
5,436 |
3,863 |
Tax |
(510) |
(948) |
(1,631) |
(1,159) |
Depreciation benefits |
338 |
338 |
338 |
338 |
Cash flow after tax |
1,527 |
2,549 |
4,143 |
3,042 |
Scrap value |
|
|
|
500 |
Project cash flow |
1,527 |
2,549 |
4,143 |
3,542 |
Discount at 11% |
0.901 |
0.812 |
0.731 |
0.659 |
Present values |
1,376 |
2,070 |
3,029 |
2,334 |
$000
PV of future cash flows 8,809
Initial investment (5,000)
Expected net present value (ENPV) 3,809
The investment project has a positive ENPV of $3,809,000. This is a mean or average NPV which will result from the project being repeated many times. However, as the project is not being repeated, the NPVs associated with each future economic state must be calculated as it is one of these NPVs which is expected to occur. The decision by management on the financial acceptability of the project will be based on these NPVs and the risk associated with each one.
Workings
Mean or average selling price = (25 × 0.35) + (30 × 0.5) + (35 × 0.15) = $29 per unit
Year |
1 |
2 |
3 |
4 |
Inflated selling price ($ per unit) |
30.16 |
31.37 |
32.62 |
33.93 |
Sales volume (units/year) |
150,000 |
250,000 |
400,000 |
300,000 |
Sales revenue ($000/year) |
4,524 |
7,843 |
13,048 |
10,179 |
Year |
1 |
2 |
3 |
4 |
Inflated overhead ($000/year) |
440 |
484 |
532 |
586 |
Total tax-allowable depreciation = 5,000,000 – 500,000 = $4,500,000
Annual tax-allowable depreciation = 4,500,000/4 = $1,125,000 per year
Annual cash flow from tax-allowable depreciation = 1,125,000 × 0.3 = $337,500 per year.