You are currently evaluating a new project for your company. The project require

Question

You are currently evaluating a new project for your company. The project requires an initial investment in equipment of RM90,000 and an investment in working capital of RM10,000 at the beginning (t = 0). The project is expected to produce sales revenues of RM120,000 for three years. Manufacturing costs are estimated to be 60% of the revenues. The asset is depreciated over the project’s life using straight-line depreciation method. At the end of the project (t = 3), you can sell the equipment for RM10,000. The corporate tax rate is 30% and the cost of capital is 15%. Should you accept the project? Why?

Explanation / Answer

Initial Investment = RM90 000 + RM10,000 = RM100,000.

Cash Flow for Year 1 & 2:

Sales Revenue = RM120,000
- Manufacturing Cost = RM72,000                   (60% of Sales Revenue)
- Depreciation = RM30,000                               (RM90,000/3 = RM30,000 per year)
PBT                   = RM18,000

Tax                     = RM5,400                                 (30% of PBT)

PAT                   = RM12,600

Cash Flow for Year 3 = RM12,000 + RM7,000                  (After tax salvage value of machine = RM10,000*70% )

                                      = RM19,600

Now, to decide whether to accept this project or not, we need to calculate the Net Present Value of the Project. If the NPV is less than 0, we will reject the project & if 0 or more, we may accept the project.

NPV = {Net Period Cash Flow/(1+R)^T} - Initial Investment

NPV of Project = -$66,628.75

As the NPV is less than 0, we will reject the project.

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