Question

All amounts are in $AUD. Blackmores is evaluating to invest into a new manufacturing facility in Asia. In order to mitigate the risk and assess the fit for purpose of this manufacturing plant Blackmores asked “SGS Ltd.” to conduct a technical due diligence on the plant and advise on the feasibility of this project. “SGS Ltd.” is asking $1 Million as a fixed fee for its consulting services. The manufacturing plant has an initial outlay of dollars $500 million and will produce 150,000,000 tablets ready for sale starting at the end of year 1 until the end of year 5 and 250,000,000 tablets starting at the end of year 6 until the end of year 10. It will also incur working capital expenses at the end of year 1 to 5 of $1 million (this working capital will not be recovered). Assume that the average selling price of a single tablet is $1 over the ten years. The operating costs of the project will be 35% of the revenues from year 1-10. The investment will be depreciated on a straight-line basis over ten years to 0 book value. Blackmores has estimated that the manufacturing plants can be sold at the end of year 10 for $10 million. The tax rate is 30%. All cash flows are annual and are received at the end of the year. The weighted average cost of capital for Blackmores is 10%.

Upload or showing your excel spreadsheet via do this questions below.

a) Based on the above information calculate the FCFs of the project.

b) Calculate the NPV for the new manufacturing facility assuming that the cost of capital is 10% and 15%. Which discount rate should Blackmores use given that this project has a higher risk than the overall risk of the company?

c) Blackmores would like to recover the investment within 5 years. What is the Discounted Payback Period for the project (both at Cost of Capital of 10% and 15%)?

d) Based on your analysis a) to d) should Blackmore undertake this project? Justify your answer with reference to theory.

e) Appropriate referencing, layout and research

Answer 1

a) Calculation of FCFs of the project

Step 1: Information given in question and key inputs

Workings

Step 2: Calculation of Operating Cash Flows (after tax):

Workings:

Step 3: Calculation of Free Cash Flows (FCF after tax):

Workings:

b) Calculation of NPV of the project at cost of capital of 10% and 15%

Since the project has a higher risk than the overall risk of the company, the company has to use higher discount rate of 15% (high risk --- high return).

Workings

c) Calculation of Discounted payback at cost of capital of 10% and 15%

Step 1: Calculating cumulative present value

Workings

Step 2: Calculation of Discounted pay-back

Discount pay-back refers to the period by when the company will be able to recover its initial investment.

For discount rate of 10%, the company recovers its initial outlay between year 7 to 8 (cumulative present value of FCF is turning positive from negative. Thus, the discounted pay back is between years 7 to 8.

Total Movement in cumulative present value of FCF from year 7 to year 8 = 10600163-(-49462662) = $60,062,825

Thus, for 12 months (between year 7 and 8), cumulative FCF has moved by $60,062,825, thus number of months it requires to move by -$49,462,662 so that cumulative FCF becomes Zero = $49,462,662/$60,062,825*12 = 9.8 or 10 months.

Thus discounted pay back for discount rate of 10% is 7 years and 10 months

Since the project has negative NPV for discount rate of 15%, discounted pay-back does not apply as the company does not recover its initial outlay during the whole of 10 years.

d) Recommendation:

The company should consider discount rate of 15% since its a high risk project. At 15% discount rate, NPV is negative. Also, even 10% rate is considered, discounted pay back is 7 years and 10 months which is higher than required pay-back of 5 years. Thus, the company should not undertake this project.