Table 1 shows the cash inflow expected to be generated and the cash outflow expected to be incurred should the proposed expansion be undertaken. During the first year, the company will incur expenses to finance the purchase of the new plant and equipment costing 5,000,000. It is assumed that this amount will be a one time expense fully incurred during the first year.

This report also recognized the need to recognize the investment in research and development already incurred by the company. The rationale behind this is to fully and adequately evaluate the profitability of the project. It should be noted that in order to come up with a proper valuation, the company should account for all the revenues and expenses generated by the project. Thus, it is inclusive of all the expenses incurred to bring the project in operation. Research and development cost of 900,000 should be accounted for because without it, the expansion will be impossible to pursue.

During 2005, the amount of 1,800,000 to cover additional working capital expenses is also included in the cash outlay required. However, management also expects that after five years, this amount will be freed up and can be readily used by other projects. Thus, Table 1 also shows that during 2005, the company will be needing 1,800,000 while this amount will be available during 2010.

In the case of the overhead costs, this report decided to use the 300,000 per annum as estimated by the project development team advisor. This is deemed appropriate as allocating 50% of the wages is just an estimate. It should also be noted that depreciation expense will not be included in the computation of the NPV because cash flow is not directly affected by the account. As taxes and inflation are excluded in the analysis, tax shield from depreciation will not be considered.

The computation for NPV is shown in Table 2. Since the company is using 14% as the required rate of return for the expansion, the cash flows are discounted at the same rate. According to the computation in Table 2, the NPV of the expansion using 14% cost of capital is (403.47).

Table 2. Discounted Cash Flow and NPV for Expansion

(2005-2010, in thousand)

2005

2006

2007

2008

2009

2010

Total Inflow/ (Outflow)

(8500)

2,040

1,940

2,140

2,140

3,940

Present Value Factor (14%)

1.0000

0.8722

0.7695

0.6750

0.5921

0.5194

Present Value

(8500)

1789.4

1492.8

1444.5

1267.0

2046.4

NET PRESE NT VALUE (403.47)

Internal Rate of Return

The internal rate of return is the cost of capital which equates the net present value of all cash flow to zero. The IRR can be computed by calculating the NPV at different interest rates. Utilizing this method, we come up with Figure 1 which shows that IRR is approximately 12%.

Figure 1 . NPV at Different Cost of Capital

Question 2. Prepare an informal report for the Board of
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