Assignment (Group Project)

This assignment is designed to test students' knowledge on capital budgeting. Students are expected to appraise the attractiveness of a capital asset proposal. The emphasis is on deriving the relevant cash flows so asto make a reasoned recommendation. Teams are to comprise between 3 and 4 members. Students must form groups within their own class.

Question (30 marks)

Neqi plc produces reusable face masks where there are 3 masks per pack. The firm is considering whether to invest in new equipment, costing 10.5 million, to manufacture a new type of reusable face mask.

Market research suggests scope to sell an additional 500,000 units per year (from the current level).The new number of units will be the same from year to year.The research fee amounted to 0.45 million and will be paid in year 1 of the project.

The pricing structure (in British pounds) of a typical mask is as follows:

Price per unitXX

Cost per unit output

Direct cost per unit1.50

Fixed overhead cost per unit1.00

(2.50)

YY

The fixed overhead represents existing fixed costs of the mask factory. Depreciation, on a straight-line basis, is 10 percent per year. The government grants Neqi plc a full tax rebate for the duration of the project due to the country's need for higher quality face masks.

This article discussed the nature of face masks and a comparison of Neqi's highly- regarded product and pricing against competitive products:

https://www.theguardian.com/world/2020/oct/30/face-mask-test-which-best-at-limiting-spread-covid

The new production line is expected to operate for five years. It requires 0.5m of initial working capital which is expected to remain constant for the next five years. Working capital will be recovered at the end of the project life. The equipment will have a residual value of 2.0 million at the end of the life of the project.

The new production line will be located in a presently empty building, purchased at 6.5 million three years ago, for which an offer of 2.5 million has recently been received from another firm.If the building is retained, it is expected that the value will rise to 3.5m after 5 years.

Neqi's strategic planning division made the following forecasts for the average annual rates of inflation relevant to the project:

Mask prices5% p.a.

Direct costs 3% p.a.

Fixed overhead costs 5% p.a.

Neqi's annual real cost of capital for projects of similar degree of risk is 8 percent. The general rate of inflation is 4.63 percent per annum.

Required:

a.What is the project's actual / monetary cost of capital?

b. Provide the reasons for the irrelevance of three cash flow items for project consideration.

c. Assess the financial viability of the proposed project using nominal/actual cash flows. Monetary figures should be in ' million and intermediate computations should be in 2 decimal places.

Note: To show all workings with accompanying explanations.

Word count requirement: 800. Minimum number of references: 2.