Question

Bright Lighting Ltd is considering a new range of product based on a specific type of intelligent stage lighting after an extensive market research costing $60,000, which was paid yesterday.

Bright expects that this range will increase the firm’s revenues by $1,565,000 in the first year of operations. Thereafter, the revenues will increase by 9.5% p.a. each year. The additional material will cost $850,000 p.a., additional labour cost is expected to be $350,000 p.a. and other miscellaneous costs are estimated to be $52,000 p.a. After the first year, Bright expect these costs will increase by 5.5% p.a. each year. [Assume that all revenues are received and that all costs are paid at the end of each year.]

The initial outlay of $2,125,000 will be depreciated on a straight-line basis to zero salvage value over the 8 year productive life of the project. It is estimated the various components of equipment can be sold for $100,000 at the completion of the project.

The firm requires a 12.5% p.a. required rate of return and the tax rate is 30%. Tax is paid in the year in which net earnings are received.

a. Calculate the incremental cash flows for each year (Y0 to Y8 inclusive). (10 marks)

b. Calculate the payback period of the project. (2 marks)

c. Calculate the net present value, that is, the net benefit or net loss in present value terms of the project. (4

marks)

d. Calculate the present value index of the project. (2 marks)

e. Calculate the discounted payback period of the project. (2 marks)

f. Calculate the internal rate of return of the project. (4 marks)

g. Now assume Bright expects a worst-case scenario where the revenues will only increase by 6% p.a. each

year but costs (other than depreciation) will increase by 10% p.a. each year.

1. Calculate the incremental cash flows for each year (Y0 to Y8 inclusive) under this scenario. (5

marks)

2. Calculate the net present value, that is, the net benefit or net loss in present value terms of the

project, under this scenario. (4 marks)

h. Now assume Bright expects a best-case scenario where the revenues will increase by 15% p.a. each

year but costs (other than depreciation) will only increase by 2.5% p.a. each year.

1. Calculate the incremental cash flows for each year (Y0 to Y8 inclusive) under this scenario. (5

marks)

2. Calculate the net present value, that is, the net benefit or net loss in present value terms of the

project, under this scenario. (4 marks)

i. Considering all three scenarios, explain if the company should accept the project or not. (5 marks)

Answer 1

a.

	Year1	Year2	Year3	Year4	Year5	Year6	Year7	Year8
Revenue	1,565,000.00	1,713,675.00	1,876,474.13	2,054,739.17	2,249,939.39	2,463,683.63	2,697,733.57	2,954,018.26
Scrap Value	-	-	-	-	-	-	-	100,000.00
Material Cost	850,000.00	896,750.00	946,071.25	998,105.17	1,053,000.95	1,110,916.01	1,172,016.39	1,236,477.29
Labour Cost	350,000.00	369,250.00	389,558.75	410,984.48	433,588.63	457,436.00	482,594.98	509,137.71
Miscellaneous Cost	52,000.00	54,860.00	57,877.30	61,060.55	64,418.88	67,961.92	71,699.83	75,643.32
Depreciation                                  (2125000-100000)/8	253,125.00	253,125.00	253,125.00	253,125.00	253,125.00	253,125.00	253,125.00	253,125.00
Income Before tax	59,875.00	139,690.00	229,841.83	331,463.97	445,805.93	574,244.70	718,297.38	979,634.95
Tax (30%)	17,962.50	41,907.00	68,952.55	99,439.19	133,741.78	172,273.41	215,489.21	293,890.49
Income after tax	41,912.50	97,783.00	160,889.28	232,024.78	312,064.15	401,971.29	502,808.17	685,744.47
Add- Depreciation	253,125.00	253,125.00	253,125.00	253,125.00	253,125.00	253,125.00	253,125.00	253,125.00
Incremental Cash Flow	295,037.50	350,908.00	414,014.28	485,149.78	565,189.15	655,096.29	755,933.17	938,869.47

b.

Initial Cost	2,125,000
	Year1	Year2	Year3	Year4	Year5	Year6	Year7	Year8
Incremental Cash Flow	295,037.50	350,908.00	414,014.28	485,149.78	565,189.15	655,096.29	755,933.17	938,869.47
Cumulative Cash Flow	295,037.50	645,945.50	1,059,959.78	1,545,109.55	2,110,298.70	2,765,394.99	3,521,328.16	4,460,197.63
Payback period	5year and 3 months
(2110298.7-2125000)	14,701.30	0.27
(Cost covers in the 6 th year, so 5 th year +)	5th year   +	0.3	5year and 3 months
		(rounded)

c.

NPV
Initial Cost	2,125,000
Discount rate	12.50%
	Year1	Year2	Year3	Year4	Year5	Year6	Year7	Year8	Total
Incremental Cash Flow	295,037.50	350,908.00	414,014.28	485,149.78	565,189.15	655,096.29	755,933.17	938,869.47
Discount factor (12.5%)	0.89	0.79	0.70	0.62	0.55	0.49	0.44	0.39
Discounted Cash flow	262,258.83	277,252.41	290,762.23	302,879.01	313,623.46	323,159.00	331,476.69	365,877.43	2,467,289.06
NPV     =           (2467289.06-2125000)	342,289.06

d.

present value index (2467289.06 / 2125000)

1.16

e.

e	discounted payback period	7 year and 8 months
	Initial Cost	2,125,000
	Discounted Cashflow	262,258.83	277,252.41	290,762.23	302,879.01	313,623.46	323,159.00	331,476.69	365,877.43
	Cumulative Cash Flow	262,258.83	539,511.24	830,273.47	1,133,152.48	1,446,775.93	1,769,934.94	2,101,411.63	2,467,289.06
	Cost covers in the 8th year, so 7 th year +
	(2101411.63-2125000)	23,588.37	0.77	(23588.37/365877.43*12)
		7 year and	0.8	months
f	IRR
	Initial Cost	-2125000
	Year1	295,037.50
	Year2	350,908.00
	Year3	414,014.28
	Year4	485,149.78
	Year5	565,189.15
	Year6	655,096.29
	Year7	755,933.17
	Year8	938,869.47
		16.18%