(b) The objective of Charles Plc is to maximise shareholder
wealth. The net present value method is used for project
appraisal and you are asked to evaluate the following
proposal for the July meeting of the capital expenditure
committee using the company's cost of capital of 12 per
cent per year.
The investment required now in machinery and equipment
is Rs1,500,000. The project is expected to have a life of
exactly five years at which time the resale value of the
machinery and equipment is anticipated to be Rs300,000.
The company uses the straightline method of depreciation.
A feasibility study has been carried out at a cost of
Rs300,000. Rs180,000 of this has just been paid and the
balance of Rs120,000 will be paid at the end of year one.
In accordance with the final product's expected life cycle,
sales will grow in volume by 20 percent per year in the
second and third year of the project's life and then decline
by 10 per cent per year in years four and five. Sales in the
first year will be 100,000 units and a selling price of Rs7.50
per unit will be maintained throughout the project's five
year life.
The cost of raw material is expected to be Rs1.10 per unit
in the first year and the unit costs will increase by five per
cent per year due to an expected rise in the world price for
this type of raw material which cannot be passed on to the
consumer.
The production process uses 15 minutes of labour time per
unit. For the first two years the hourly rate of pay will be
Rs9. A new pay deal is expected to be agreed in two years'
time and the hourly rate of pay from the start of year three
is expected to increase by 10 per cent and remain
unchanged for the rest of the project's life.
Assume the corporate tax rate is 20 percent. Make and
state all necessary assumptions.
Required
Prepare detailed calculations indicating whether or not the
company should proceed with the project together with
your reasoned advice.
(30 marks)
