Capital Budgeting-5 page
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Assume that you are an adviser at LATECH Ltd, which is analysing the introduction of a new game console named NEUROPOWER. This system can be connected with human brain functions, and is still very much controversial for claimed but yet to be confirmed adverse impacts on human behaviour after prolonged application. Health conscious groups are also lobbying against introduction of such games with probable detrimental effects.
The Project Manager of LATECH Ltd needs a detailed analysis of this exciting NEUROPOWER project. She comes into your office, drops a consultants report on your desk, and complains, ‘We paid these consultants $1 million for this report, and I am not sure their financial analysis makes sense, though their estimations seem to be correct. Before we spend $60 million on buying new equipment needed for this project, look it over and give me your opinion.’ You open the report and find the following information and estimates:
The project will continue for the next seven years, and by that time more reliable information on possible adverse impacts of using NEUROPOWER will be available. It is projected that equipment will have an economic life of 10 years. After buying the equipment, it requires renovation of the production bay at LATECH Ltd and installation of the equipment at a total cost of $2 million. These renovation and installation costs are to be considered as capital expenditures. A staff training cost of $200,000 is to be incurred initially at the start of the project.
The equipment will be procured from Germany and LATECH Ltd has to pay 8% import duty on purchase price, whereas the supplier will pay transportation costs of $90,000. These property, plant and equipment (PPE) would be depreciated over their useful life of 10 years using a tax allowable straight line rate of 10%. However, the company is planning to sell the equipment at the end of the project for an estimated price of $12 million.
Consultants estimate that 96,000 NEUROPOWER consoles can be sold in the first year with an expected increase by 25% in each year for the next two years; afterwards, sales are expected to decrease by 20% in each year until the end of the project, due to a number of actions by the competitors in the market. Annual fixed operating cost, excluding depreciation, will be $1 million. Variable operating costs will be 50% of sales. Beginning selling price per console will be $500, which will be dropped by 10% in the fourth year for the rest of the project life.
Existing facilities to be used for the NEUROPOWER project are coming from another production line that earns net $21,000 per month. That production line will be discontinued on the commencement of the NEUROPOWER project. For the duration of the project, LATECH is also planning to take the service of a market analyst at a cost of $9,000 per month.
It is also estimated that the new production line will require an initial increase in investment for $970,000 in stock (inventories) and $910,000 in debtors (accounts receivable) that are offset by an increase in creditors of $480,000 (accounts payable). There will be no further investment in net working capital (NWC) until its final recovery at the end of project life.
The company uses required rate of return considering its weighted average cost of capital (WACC) that varied from 16% to 22% in recent times. The analyst is confused about the rate to be effective for the project; however, she has decided to use 16% required rate to evaluate this project. Corporate tax rate is 30%. The required discounted payback period is five years.
The Project Manager hesitates to take the final decision because of unexpected growth in the game industry, with technological advancement in different directions. As an alternative, LATECH has an offer to introduce an upgraded version of a safe traditional game console, the IQFORCE. Initial total investment for this IQFORCE project would be the same as the NEUROPOWER project and projected net future cash flows (after all adjustments) would be as follows:
Year 1: $30,400,000; Year 2: $29,200,000; Year 3: $19,700,000;
Year 4: $17,500,000; Year 5: $15,200,000; Year 6: $10,000,000;
Before taking the final decision in the upcoming meeting, the Project Manager of LATECH Ltd requires a clear explanation of all relevant issues relating to the NEUROPOWER project. Particularly, a formal report is enquired by the Project Manager to include a detailed analysis of cash flows and explanations of results of capital budgeting methods that are commonly used in evaluating projects. Furthermore, in a separate section in the report, the Project Manager is interested in reviewing a detailed comparison between the NEUROPOWER and IQFORCE projects, with regard to the results of applicable capital budgeting methods using both 16% and 22% required rates, crossover rate and all relevant factors that can assist in taking the final decision.
Your assignment will require the following:
Using an Excel spreadsheet, prepare a full analysis to be presented to the Project Manager of LATECH Ltd to assist in evaluating whether either project should be started or not.
Your analysis should include the following: table of cash flows (show all digits, do not convert amounts to $ in million or thousand) use of Excel formulae where appropriate a written report (1500 words, +/- 10%) outlining your recommendation as to whether LATECH Ltd should proceed with either project.
Justify your recommendations using quantitative and qualitative issues, and your analysis of probable risks and benefits relating to the project. Comparison statement is to be presented in a separate section in the report. You will submit the following documents:
