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You have been conducting a detailed review of an investment project proposed by one of the divisions of your business. Your review has two aims: first to correct the proposal for any errors of principle and second, to recommend a financial measure to replace payback as one of the criteria for acceptability when a project is presented to the company's board of directors for approval. The company's current weighted average cost of capital is 10% per annum.

The initial capital investment is for $150 million followed by $50 million one year later. The post tax cash flows, for this project, in $million, including the estimated tax benefit from capital allowances for tax purposes, are as follows:

 

Year

0

1

2

3

4

5

6

Capital investment (plant and machinery):

 

 

 

 

 

 

 

 First phase

–127.50

           

Second phase

 

–36.88

 

 

 

 

 

Project post tax cash flow ($ milllons)

 

 

44

68

60

35

20

 

 

Company tax is charged at 30% and is paid/recovered in the year in which the liability is incurred. The company has sufficient profits elsewhere to recover capital allowances on this project, in full, in the year they are incurred. All the capital investment is eligible for a first year allowance for tax purposes of 50% followed by a writing down allowance of 25% per annum on a reducing balance basis.

You notice the following points when conducting your review:

  1. An interest charge of 8% per annum on a proposed $50 million loan has been included in the project's post tax cash flow before tax has been calculated.
  2. Depreciation for the use of company shared assets of $4 million per annum has been charged in calculating the project post tax cash flow.
  3. Activity based allocations of company indirect costs of $8 million have been included in the project's post tax cash flow. However, additional corporate infrastructure costs of $4 million per annum have been ignored which you discover would only be incurred if the project proceeds.
  4. It is expected that the capital equipment will be written off and disposed of at the end of year six. The proceeds of the sale of the capital equipment are expected to be $7 million which have been included in the forecast of the project's post tax cash flow. You also notice that an estimate for site clearance of $5 million has not been included nor any tax saving recognised on the unclaimed writing down allowance on the disposal of the capital equipment.

Requirements:

  1. Prepare a corrected project evaluation using the net present value technique supported by a separate assessment of the sensitivity of the project to a $1 million change in the initial capital expenditure.    (14 marks)
  2. Estimate the discounted payback period and the duration for this project commenting on the relative advantages and disadvantages of each method.     (5 marks)

 

Marks: 19
c

Recommend whether this project is acceptable and also which techniques the board should consider when reviewing capital investment projects in future.  (6 marks)

Marks: 6