Question

*I am seeking an answer for Question 2. I have posted Question 1 for context.*

Question 1) ABC company is considering producing a new range of smartphones that will require it to build a

new factory. Feasibility studies have been done on the factory which cost $5 million. The studies

have found the following:

1. The factory will cost $25 million and will have a useful life of 20 years.

2. The land where the factory will go is currently used as a carpark for workers and it is assumed that the company will have to pay $200000 per year for their workers to park in a nearby carpark.

3. The factory will be depreciated on a straight line basis and will have a salvage value of $0 but it is believed that most of it can be sold for scrap after 20 years for $50000.

4. Due to the nature of the business they are in, they will have to perform some environmental tests to make sure that some of the chemicals they are using are not entering the ground water around the factory. These tests will be performed every 5 years and cost $625000.

5. Through the building of this factory and the selling of the phones it produces, it’s revenue will increase by $5 million in year 1 and remain at this level for the operational life of the factory.

6. The extra costs that the company accrues per year due to the project are $435000 for labour, $50000 for overhead like power and water bills and marketing costs for the new line of phones will be $500000 per year but will decrease by $15000 per year as the phone gains greater penetration.

7. The company’s current cost of capital is 8% per year.

8. The tax rate is 30%.

9. The project requires an initial investment in working capital of $1000000 that is returned

   in year 20.

Question 2) Use the information from Question 1 and the extra information below to answer the following.

A. If the economy goes into a recession, the company foresees that the situation will change in the following way (all changes occur from year 0):

1. The revenue per year will decrease by 20% due to a lack of demand.

2. The costs (not including depreciation) will decrease by 10% due to a lack

   of competition in the economy. This includes the environmental test that

   have to be undertaken every five years.

3. The company’s cost of capital will increase to 10% to reflect the extra risk

   it faces.

What will be the new NPV, IRR and payback period be? If the company knew for certain that a recession would occur, should they go ahead with the project? ​

Answer 1

Ans.2) With recession, NPV = -2,931,002.21 and IRR = 8.15%

Company should not go ahead with the project if it is certain that recession will occur as it will be a loss making project given its negative NPV and IRR which is less than the required return of 10%.

Payback period calculation: It can be seen from the cumulative FCF that cash flows turn positive in Year 10, so

payback period = 9 + (cumulative cash in Year 9/cash flow in Year 10) = 9 + (1,935,000/2,082,250) = 9.929 years