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)
Year 0 1 2 3 4
Units Sold 3,200 4,300 3,900 2,800
Price per unit 780 800 820 840
Total Revenue 2,496,000 3,440,000 3,198,000 2,352,000
Variable cost (15%) 374,400 516,000 468,000 344,400 Variable cost has to be adjusted to make it Rm 120 & 123 for 3rd & 4th year
Fixed Cost 425,000 425,000 425,000 425,000
Depreciation 987,500 987,500 987,500 987,500
Income before tax 709,100 1,511,500 1,317,500 595,100
Tax (38%) 177,275 377,875 329,375 148,775
Net Income 531,825 1,133,625 988,125 446,325
Operating Cash Flow 1,519,325 2,121,125 1,975,625 1,433,825 Net Income + Depreciation
Land
Equipment (4,200,000)
After Tax Salvage 187,500 Since the book value is zero, all amount received will be taxed at 25%
Net Working Capital (125,000) 125,000 Working Capital will be recovered at the end of project
Total Cash Flow (4,200,000) 1,394,325 2,121,125 1,975,625 1,746,325
NPV (13%) 1,135,329
the tax should be 25%... plz help is this the correct way.. especially the depriaction part....
To calculate the project's cash flow for each of the next four years, we need to consider the revenue, expenses, and taxes. Let's break it down step by step:
1. Revenue calculation:
- In the first year, the company can sell 3,200 units at RM780 each, giving a total revenue of 3,200 * RM780 = RM2,496,000.
- In the second year, the company can sell 4,300 units at RM800 each, giving a total revenue of 4,300 * RM800 = RM3,440,000.
- In the third year, the company can sell 3,900 units at RM820 each, giving a total revenue of 3,900 * RM820 = RM3,198,000.
- In the fourth year, the company can sell 2,800 units at RM840 each, giving a total revenue of 2,800 * RM840 = RM2,352,000.
2. Variable costs calculation:
- For the first two years, variable costs are 15% of sales. So, in the first year, variable costs will be 0.15 * RM2,496,000 = RM374,400, and in the second year, it will be 0.15 * RM3,440,000 = RM516,000.
- In the third year, the variable cost per unit is RM120, and the number of units sold is 3,900. So, the variable costs will be RM120 * 3,900 = RM468,000.
- In the fourth year, the variable cost per unit is RM123, and the number of units sold is 2,800. So, the variable costs will be RM123 * 2,800 = RM344,400.
3. Fixed costs calculation:
- The fixed costs for the project are RM425,000 per year.
4. Tax Calculation:
- The tax rate is 25%.
Now, let's calculate the cash flow for each year:
Year 1:
Revenue: RM2,496,000
Variable costs: RM374,400
Fixed costs: RM425,000
Profit before tax: RM2,496,000 - RM374,400 - RM425,000 = RM1,696,600
Tax: 25% of RM1,696,600 = RM424,150
Net profit: RM1,696,600 - RM424,150 = RM1,272,450
Cash flow: Net profit + Depreciation + Change in Working Capital
Depreciation: RM4,200,000/4 = RM1,050,000
Working Capital: 5% of RM2,496,000 = RM124,800
Cash flow: RM1,272,450 + RM1,050,000 + RM124,800 = RM2,447,250
Similarly, we can calculate the cash flow for years 2, 3, and 4 using the same formula.
Year 2: RM2,593,100
Year 3: RM2,143,100
Year 4: RM1,584,600
Now let's move on to the next question:
B. To calculate the payback period, we need to determine in which year the initial investment is recovered. The payback period is the time required to recover the initial investment.
Initial investment: Marketing firm cost + Equipment cost + Net working capital
Initial investment: RM125,000 + RM4,200,000 + RM125,000 = RM4,450,000
To find the payback period, subtract each year's cash flow from the initial investment until the sum is zero or positive. The year in which this happens is the payback period.
Payback period: Year 2.
Based on the payback period, where the initial investment is recovered by the end of the second year, MHSB may consider investing in this project. However, the payback period should also be evaluated in combination with other factors such as profitability and risk.
Moving on to the final question:
C. To compute the net present value (NPV) of the project, we need to discount the cash flows to the present value. The NPV is the difference between the present value of cash inflows and the present value of cash outflows.
The formula for NPV calculation is:
NPV = (CF1 / (1 + r)^1) + (CF2 / (1 + r)^2) + (CF3 / (1 + r)^3) + (CF4 / (1 + r)^4) - Initial Investment
Where:
CF1, CF2, CF3, CF4 are the cash flows in each respective year.
r is the required rate of return.
Initial Investment is the sum of the initial costs.
Using the given required rate of return of 13%, we can calculate the NPV.
NPV = (RM2,447,250 / (1 + 0.13)^1) + (RM2,593,100 / (1 + 0.13)^2) + (RM2,143,100 / (1 + 0.13)^3) + (RM1,584,600 / (1 + 0.13)^4) - RM4,450,000
NPV = RM2,159,506.29
If the NPV is positive, it indicates that the project is expected to generate positive value and can be considered. In this case, since the NPV is positive (RM2,159,506.29), MHSB should proceed with the project.