Firm A is a manefacturer who has recently developed a new product XYZ. Market research has shown
the firm is now considering wether or not to go ahead with a project to sell XYZ for 4 years.
The contribution ( selling price minus variable costs) per XYZ will be £640.
The project would require machinery to be bought now at the cost of £8 million. At the end of four years, the value of the machinery will be zero. The firm can claim a tax benefit from deprectiaion ( capital allowences) on the machinery. The deprectiation will be 25% of the machinery cost per year. Firm A's cost of capital is 16%, and the tax rate is 25%.
Assume all cash flows occur at the end of the year except for those that occur now.
(a) What is the total present value of the after-tax contribution for years 1-4 in the high-demand and low-demand cases? What is the NPV of the machinery cashflows in each case? (Do not forget to take into account the deprectiation tax benefits in your NPV calculation)
(b) What is the expected NPV of the XYZ project?
(c) Firm A cannot delay starting the XYZ project, but it can abandon it in one year (after the first year's cash flows). The machinery can be sold for its written down value (net of deprectiation)
What is the value now of the option to abandon? Is the project worthwhile?
(d) Cobsider the following additional information:
i. the firm can raise the funds to invest in the machinery either by cutting the devidend it is about to pay or by borrowing at an interest rate of 6%.
ii. Some equipment used in developing XYZ is no longer needed for this project. Firm A can modify it for use in another project, ABC, instead of spending £20,000 on new equipment for project XYZ.
Assess wether or not each piece of information is relevant for the analysis of the XYZ project ( no calculation needed for this part )