You have been hired as a consultant for Melody Harmonitune Sdn. Bhd. (MHSB), a manufacturer of fine zithers, to evaluate a capital budgeting proposal. MHSB observes that the market for zithers is growing quickly. To confirm their observation, the company hired a marketing firm to analyse the zither market, at a cost of RM125,000. An excerpt of the marketing report is as follows:
The zither industry will have a rapid expansion in the next four years. With the brand name recognition that MHSB brings to bear, we feel that the company will be able to sell 3,200, 4,300, 3,900, and 2,800 units each year for the next four years, respectively. Again, capitalising on the name recognition of MHSB, we feel that a premium price of RM780 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued.
MHSB agrees to the suggested price for the first year but intends to raise it by RM20 each year. MHSB also believes that fixed costs for the project will be RM425,000 per year, and variable costs are 15 percent of sales for the first two years. Due to inflation MHSB expects that the variable cost per unit will increase to RM120 and RM123 for the third and fourth year, respectively. The equipment necessary for production will cost RM4.2 million and will be depreciated using the straight-line method down to zero by the end of the project period. However, MHSB estimates that the equipment will have a scrap value of RM250,000 at the end of the fourth year. Net working capital of RM125,000 will be required immediately, and thereafter, the working capital requirements will be at 5 percent of sales. MHSB has a 25 percent tax rate, and the required return on the project is 13 percent.
A. What is the project’s cash flow for each of the next four years?
(15 marks)
B. What is the payback period? Based on your answer, would you recommend MHSB to invest in this project?
(5 marks)
C. Compute the net present value of the project. Should MHSB proceed with the project? Why or why not?
(5 marks)
Please note that no one here will do your work for you. However, we will be happy to read over what YOU THINK and make suggestions and/or corrections.
Please post what you think.
To determine the project's cash flow for each of the next four years, we need to consider several factors mentioned in the excerpt:
1. Sales revenue: The number of zithers sold each year and the corresponding unit price.
Year 1:
Sales revenue = Number of units sold * Unit price
= 3,200 * RM780
= RM2,496,000
Year 2:
Sales revenue = 4,300 * (RM780 + RM20)
= RM3,486,000
Year 3:
Sales revenue = 3,900 * (RM780 + 2 * RM20)
= RM3,726,000
Year 4:
Sales revenue = 2,800 * (RM780 + 3 * RM20)
= RM2,856,000
2. Variable costs: These costs are stated as a percentage of sales for the first two years and then as specific amounts for the next two years.
Year 1-2:
Variable costs = 15% * Sales revenue
= 0.15 * Sales revenue
Year 3:
Variable costs = 0.15 * (RM3,726,000) (as stated in the excerpt)
= RM558,900
Year 4:
Variable costs = 0.15 * (RM2,856,000) (as stated in the excerpt)
= RM428,400
3. Fixed costs: These costs are stated as a specific amount per year.
Fixed costs = RM425,000
4. Depreciation: The cost of the equipment necessary for production and its salvage value at the end of the project period.
Depreciation expense = (Equipment cost - Salvage value) / Project period
= (RM4,200,000 - RM250,000) / 4
= RM987,500
5. Working capital: The initial working capital required and the subsequent amount based on a percentage of sales.
Initial working capital = RM125,000
Working capital (Year 1) = 5% * Sales revenue (Year 1)
= 0.05 * Sales revenue (Year 1)
Working capital (Year 2) = 0.05 * Sales revenue (Year 2)
Working capital (Year 3) = 0.05 * Sales revenue (Year 3)
Working capital (Year 4) = 0.05 * Sales revenue (Year 4)
Now, let's calculate the cash flow for each of the next four years:
Year 1:
Cash flow = Sales revenue - Variable costs - Fixed costs - Depreciation - Working capital (initial)
= RM2,496,000 - (0.15 * RM2,496,000) - RM425,000 - RM987,500 - RM125,000
Year 2:
Cash flow = RM3,486,000 - (0.15 * RM3,486,000) - RM425,000 - RM987,500 - Working capital (Year 1)
Year 3:
Cash flow = RM3,726,000 - RM558,900 - RM425,000 - RM987,500 - Working capital (Year 2)
Year 4:
Cash flow = RM2,856,000 - RM428,400 - RM425,000 - RM987,500 - Working capital (Year 3) - Salvage value
By calculating these cash flows for each year, we will provide you with the values.