ELC Electrical Services is considering the construction of a plant to manufactur
ID: 2768000 • Letter: E
Question
ELC Electrical Services is considering the construction of a plant to manufacture a new energy saving device for small offices. The company recently commissioned a $100,000, two-year study to assess the market demand for the proposed product. It estimated that 30,000 units of its new product could be sold annually over the next 10 years at a price of $10,000 each. Subcontractors would install each device at a cost of $6,200 per installation. The project involves an initial outlay of $60 million to build production facilities and $4 million in land. The $60 million facility will be depreciated using the prime cost method over the project’s life (fully depreciated at the end of the project). Fixed costs of $12 million per annum will be incurred. The facilities, including the land will be sold for an estimated value of $15 million at the end of the project. The land value is assumed to stay constant throughout the lifespan of the project. The company is an ongoing profitable business and pays taxes at a 30% rate in the year of income. It uses a 15% per year discount rate on the new project. Using the NPV approach, determine whether the project should be undertaken (use the relevant tax rate in your analysis).
Explanation / Answer
Given data per year
Cash in flows :
Annual sale : 30000 units × $10000 = $ 300 million ( A)
Annual Depreciation of building : ( 60 - 14.06 *) / 10 years = 4.59 million p.a (B)
* As Salvage value of land plus building both are given and we are calculating depreciation only for building as land is not depreciable assets . Hence proportion applicable to building is 15 million × 60/64 = 14.06
Total cash inflow per annum (A+B) = 300 + 4.59 = 304.59 million
Now deduct cost associated on annual basis to run the production from the above cash inflow
Installation cost = $ 6200 × 30000 = 186 million
Fixed cost p.a = 12 million
Hence net cash inflow per annum = $304.59 - 186 - 12 = 106.59 million
Initial cash outlay = land + building = 4 + 60 = 64 million
Calculation of NPV in millions
NPV = 106.59/(1+0.15)^1+106.59/(1+0.15)^2×106.59/(1+0.15)^3+106.59/(1+0.15)^4+106.59 /(1+0.15)^5+106.59/(1+0.15)^5+106.59/(1+0.15)^6 + 106.59/(1+0.15)^7+106.59/(1+0.15)^8+106.59/(1+0.15)^9+106.59/(1+0.15)^10 -64
NPV = 92.69 + 80.63+70.08+60.94+53.00+46.08+40.07+34.84+30.30+26.34 -64
NPV = 470.97 million
As NPV is positive more than zero hence project is accepted
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