Question

Howell Petroleum is considering a new project that complements its existing business. The machine required for the project costs GH¢3.8 million. The marketing department predicts that sales related to the project will be GH¢2.5 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straightline method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. Howell also needs to add net working capital of GH¢ 150,000 immediately. The additional net working capital will be recovered in full at the end of the project’s life. The corporate tax rate is 35 percent. The required rate of return for Howell is 16 percent. Should Howell proceed with the project?

Answer 1

First we will calculate cashflow per year

Sales = 2.5 million

Less 25% Operating expenses = 2.5×25% = 0.625

EBDT = 1.875

Less depreciation = 3.8/4 = 0.95

EBT = 0.925

Less tax @ 35% = 0.32375

EFT = 0.32375

Add depreciation =0.95

= 1.27375

Working capital will be invested in first year and will be realised as terminal value

Required return = 16%

P.v of cash inflows = 1.27375(PVIFA 16%4Y)+0.15(PVIF 16% 4y)

= 1.2737(2.7982) + 0.15(0.5523)

= 3.6469

P.v of cash outflow is 3.8 + 0.15 = 3.95

N.p.v is 3.6469 - 3.95 = -0.3

As Npv is negitive project should be rejected