17 Jul WHAT DOES THIS NPV INDICATE ABOUT THE POTENTIAL VALUE RWE MIGHT CREATE BY PURCHASING THE NEW PRODUCTION LINE? EXPLAIN.
RWE Enterprises Pty Ltd is a small manufacturing firm located in Brisbane. RWE is considering setting-up a new plant. The plant has an upfront cost of $3 million. The proposed plant will have a life of 10 years at the end of which it can be sold for an after-tax scrap value of $200,000. The management estimates that the new plant will add 700,000 to after-tax profits during each year of its life. Midway through its life, that is, at the end of 5 years, the plant will have to be refurbished at a cost of $2 million.
a) What are the full 10 year cash flows associated with the plant? That is, make a cash flow diagram showing the yearly cash flows from year 0 to 10.
b) If RWE uses a 10% discount rate to evaluate investments of this type, what is the net present value of the project? What does this NPV indicate about the potential value RWE might create by purchasing the new production line? Explain.
c) Calculate the internal rate of return and profitability index for the proposed investment. What do these two measures tell you about the project’s viability? Explain.
d) Calculate the payback period for the proposed investment. Interpret your findings.
Question 2 (10 marks)
Jason Katz graduated from University of the Sunshine Coast in December and has started working for Innovative Investments. When Jason arrived at work on Monday morning, he found the following memo on his desk
“To: Jason Katz, Financial Analyst
From: George Adams, CFO
RE: Project Evaluation
Provide an evaluation of two proposed projects with the following cash flow forecasts:
Project A Project B
Initial Outlay (275000) (275000)
Year 1 50000 100,000
Year 2 75000 100,000
Year 3 100,000 100,000
Year 4 125,000 100,000
Year 5 175,000 100,000
The company requires a rate of return on both projects equal to 12%. As you are no doubt aware, we rely on a number of criteria when evaluating new investment opportunities. In particular, we require that projects that are accepted have a payback of no more than three years, provide a positive NPV and have an IRR that exceeds the firm’s discount rate.
Give me your thoughts on these two projects by 9 am tomorrow morning.”
Jason was not surprised by the memo, for he had been expecting something like this for some time. Innovative Investments followed a practice of testing each new financial analyst with some type of project-evaluation exercise after the new hire had been on the job for a few months.
After re-reading the memo, Jason decided on his plan of attack. Specifically, he would first do the obligatory calculations of payback, NPV and IRR for both projects. Jamie knew the CFO would grill him thoroughly on Tuesday morning about his analysis, so he wanted to prepare well for the experience. One of the things that occurred to Jason was that the memo did not indicate whether the two projects were independent or mutually exclusive. So, just to be safe, he thought he had better rank the two projects in case he was asked to do so tomorrow morning. Jason sat down and made up the following ‘to do’ list:
(a) Calculate payback, NPV and IRR for both projects.
(b) Evaluate the two projects’ acceptability using all three decision criteria (listed above) and based on the assumption that the projects are independent. That is, both could be accepted if both are acceptable.
(c) Rank the two projects and make a recommendation as to which (if either) project should be accepted under the assumption that the projects are mutually exclusive.
Assignment—Prepare Jason’s evaluation for his Tuesday meeting with the CFO by filling out your response
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