Honest Diamonds Ltd (HD) is considering investing in a new project to extract diamonds from a...

  

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Honest Diamonds Ltd (HD) is considering investing in a new project to extract diamonds from a newly found source located in caves in Australia. Inspectors were hired two (2) years ago, and have spent eighteen (18) months assessing the potential of the caves, incurring £1.8 million cost. The inspection cost has not been paid yet, but will be paid at the end of Year 1. As a result of their analysis, the required new equipment's capital cost is estimated at £18.4 million, payable before operations begin, with residual value of £6.4 million at the end of the project in four years' time, when there are no more diamonds left to mine in the caves. Due to the nature of the market as well as the remarkable properties of the caves, the diamonds are cut into 5 gram (5g) portions. This will give merchants the ability to have one 25 carat diamond block which they can refine into their customers' unique preferences. Estimates of revenues and costs arising from this project are: Year 1 Year 2 Sales price (£/portion) Sales volume (100g) Variable cost (£/portion) Depreciation of equipment (£m) Head office costs (£m) Inspection Costs (£m) Interest payments (£m) 70,000 21 50,000 -3 -0.9 -1.8 -3 75,000 18 50,000 -3 -0.9 -3 Year 3 75,000 16 55,000 -3 -0.9 -3 Year 4 80,000 14 60,000 -3 -0.9 -3 If the project goes ahead, sales of other existing products will be lost resulting in a loss of contribution of £15 million a year, over the life of the project. HD's accountant has informed you that the head office costs include £600,000 for managing this new project, and £300,000 which accounts for a fair apportionment of the total overheads of the company. A separate study has indicated that if the new equipment is bought, additional overheads, including equipment depreciation, arising from mining the diamonds would be £ 4.5 million a year. Once the project is finished, HD have been instructed by the local authorities to restore the surrounding environment to a satisfactory standard at least equal to that when it was discovered. It is estimated the cost for this will be £2.2 million, and is to be paid at the end of Year 5. Production would require additional working capital of £30 million immediately and from Year 2, it will increase each year by a further £5 million. The working capital is used until the end of the 4 years and is then no longer required to support the project. The business has a cost of capital of 8%. For the purposes of your calculations, ignore taxation. Required: a) Calculate the net present value for the project. In so doing, clearly show the annual cash flows (and their break down) associated with this project. Use the discount table (three decimal places) provided at the end of the exam script. Do not use the auto function in Excel. Show your calculations and present your answer in £ million to two decimal places where relevant. [10 marks] Calculate the payback period for the project (to two decimal places) and show your full workings. [2 marks] Honest Diamonds Ltd (HD) is considering investing in a new project to extract diamonds from a newly found source located in caves in Australia. Inspectors were hired two (2) years ago, and have spent eighteen (18) months assessing the potential of the caves, incurring £1.8 million cost. The inspection cost has not been paid yet, but will be paid at the end of Year 1. As a result of their analysis, the required new equipment's capital cost is estimated at £18.4 million, payable before operations begin, with residual value of £6.4 million at the end of the project in four years' time, when there are no more diamonds left to mine in the caves. Due to the nature of the market as well as the remarkable properties of the caves, the diamonds are cut into 5 gram (5g) portions. This will give merchants the ability to have one 25 carat diamond block which they can refine into their customers' unique preferences. Estimates of revenues and costs arising from this project are: Year 1 Year 2 Sales price (£/portion) Sales volume (100g) Variable cost (£/portion) Depreciation of equipment (£m) Head office costs (£m) Inspection Costs (£m) Interest payments (£m) 70,000 21 50,000 -3 -0.9 -1.8 -3 75,000 18 50,000 -3 -0.9 -3 Year 3 75,000 16 55,000 -3 -0.9 -3 Year 4 80,000 14 60,000 -3 -0.9 -3 If the project goes ahead, sales of other existing products will be lost resulting in a loss of contribution of £15 million a year, over the life of the project. HD's accountant has informed you that the head office costs include £600,000 for managing this new project, and £300,000 which accounts for a fair apportionment of the total overheads of the company. A separate study has indicated that if the new equipment is bought, additional overheads, including equipment depreciation, arising from mining the diamonds would be £ 4.5 million a year. Once the project is finished, HD have been instructed by the local authorities to restore the surrounding environment to a satisfactory standard at least equal to that when it was discovered. It is estimated the cost for this will be £2.2 million, and is to be paid at the end of Year 5. Production would require additional working capital of £30 million immediately and from Year 2, it will increase each year by a further £5 million. The working capital is used until the end of the 4 years and is then no longer required to support the project. The business has a cost of capital of 8%. For the purposes of your calculations, ignore taxation. Required: a) Calculate the net present value for the project. In so doing, clearly show the annual cash flows (and their break down) associated with this project. Use the discount table (three decimal places) provided at the end of the exam script. Do not use the auto function in Excel. Show your calculations and present your answer in £ million to two decimal places where relevant. [10 marks] Calculate the payback period for the project (to two decimal places) and show your full workings. [2 marks]

Answer rating: 100% (QA)

Net Present Value Year 1 Revenue 70000 x 21 1470000 Costs 50000 x 21 1050000 Depreciation 3 Head off... View the full answer