VIP Chemical Industries is looking to set up a new plant and expand its operatio

ID: 2757070 • Letter: V

Question

VIP Chemical Industries is looking to set up a new plant and expand its
operations. The company currently has an option to buy an existing building
for £480,000, with the necessary equipments to operate the plant costing
£320,000. The initial working capital investment is £240,000.

The plant’s estimated economic life is four years. At the end of four years,
the building is expected to have a market value of £300,000 and book value
of £436,320. The equipment is expected to have market value of £80,000
and book value of £54,400.

The other available information is as follows:
Annual sales £1,600,000

Fixed costs (excluding depreciation) £200,000

Depreciation on building and equipment (Year 1 £70,240; Year 2 £114,880;
Year 3 £73,280; Year 4 £50,880)
Variable costs 60% of sales
Marginal tax rate 40%
Cost of capital 12%
Assume that operating cash flows occur at the end of each year.
The operations will begin immediately after the investment is made, and the
first operating cash flows will happen exactly one year later.

Evaluate whether the project should be accepted or not using the net present
value (NPV) and internal rate of return (IRR). (20 marks)

Airline companies often engage in jet fuel hedging. The notes to the financial
statements section of the annual report, generally provides additional
information about the hedging activities of a company.

Obtain the most recent annual report of an airline company which hedges its jet fuel requirements.
Prepare a report (maximum 1200 words) to evaluate the instruments used to
mitigate the risk of rising fuel costs, and discuss the impact of jet fuel hedging
on the financial statements of the airline company. (20 marks)

Explanation / Answer

Step 1: Initial Investment at Year 0

Cost of building = £480,000

Cost of equipments = £320,000

Initial working capital investment = $240,000

Initial outflow at year 0 = Cost of building + Cost of equipments + Working capital investment = £480,000 + £320,000 + £240,000 = £1,040,000

Step 2: Free cash flow from Year 1 to Year 4

Free cash flow = Net income after taxes + Depreciation expense

Free cash flow calculation can be tabulated as below:

Year 1

Year 2

Year 3

Year 4

Sales

£1,600,000

Variable costs

-£960,000

Fixed costs

-£200,000

Depreciation

-£70,240

-£114,880

-£73,280

-£50,880

Net income

£369,760

£325,120

£366,720

£389,120

Tax @ 40%

-£147,904

-£130,048

-£146,688

-£155,648

Net income after taxes

£221,856

£195,072

£220,032

£233,472

Add: Depreciation

£70,240

£114,880

£73,280

£50,880

Free cash flow

£292,096

£309,952

£293,312

£284,352

Step 3: Terminal cash flow at Year 4

Market value of building and equipments = £300,000 + £80,000 = £380,000

Book value of building and equipments = £436,320 + £54,400 = £490,720

Loss on sale of building and equipments = £490,720 - £380,000 = £110,720

Since there is loss on sale of assets, there will not be any tax payable on the sale transaction.

Net proceeds on sale on building and equipments = £380,000

The working capital invested at year 0 shall be released in year 4.

Total terminal cash inflow at year 4 = £380,000 + £240,000 = £620,000

Step 4: Net present value

Present value of free cash flows = £292,096/1.12 + £309,952/1.122 + £293,312/1.123 + £284,352/1.124 = £897,391.43

Present value of terminal cash inflow = £620,000 / 1.124 = £394,010

Net present value = -Initial investment + Present value of free cash flows + Present value of terminal cash flow = -£1,040,000 + £897,391.43 + £394,010 = £251,401.43

Net present value = £251,401.43

IRR is the rate of return at which NPV Is zero.

By trial and error method, IRR of the above project can be calculated as 21.02%

Since NPV is positive and the IRR of the project is greater than the cost of capital, the project should be accepted.