NaCl ltd, the sister company of H20 ltd, is evaluating a new project to produce a healthier type of sea salt used for cooking. A new equipment for the project is to be purchased at an aggregate cost of £300,000, including shipping and installation. It will be installed immediately, and commercial operations will commence from the start of the project. Sales revenue from the new project is estimated at £600,000 per annum and operating costs are expected to be 40% of sales revenue. The estimated time horizon for the project is 15 years, at the end of which equipment's residual value is expected to be negligible. 

The following additional information has been collected and presented to NaCl ltd's finance manager. 

- A sum of £20,000 is expected to be spent on renovating one section of the existing premises to accommodate the new equipment. 

- About 10% of the value of the equipment will need to be replaced every year and, for tax purposes, the replacement of this equipment can be charged to company's profit or loss statement as maintenance expenditure. 

- For accounting purposes the equipment cost of £300,000 is proposed to be depreciated on a straight line basis over a period of 15 years - i.e. a sum of £20,000 would be charged annually to the profit or loss statement as depreciation.

 - The company pays corporation tax at 28%. 

- Plans for the new project have been drawn up by a firm of consultants, whose bill of £45,000 is pending for payment. 

- The company does not propose to appoint any additional managers, although the consultants' study suggests that if they do not do so, management time spent on the new project would result in the company's existing business suffering a reduction of contribution to the extent of £180,000 per annum. 

- The additional selling, general and administrative overheads on account of the new product are expected to be negligible, since it would be marketed and distributed together with the existing product. Nevertheless, the management considers it fair to apportion £30,000 per year of NaCl ltd's existing overhead costs to the new project. 

- In addition to equity capital NaCl ltd also uses loan capital, on which it is expected to pay interest charges of £35,000 per year on account of this project. 

- The above costs and revenues are at current prices. Although inflation is expected to average about 3% for the foreseeable future, NaCl ltd's finance manager does not intend to adjust the cash flows for inflation, as she feels it would complicate the project's risk appraisal - instead she proposes to use a discount rate that is appropriate for dealing with the unadjusted cash flows. 

- NaCl ltd's weighted average cost of capital, calculated on the basis of market rates of return for investments of this level of risk, is 11.24%. It may be assumed that all cash flows occur at year ends (except those occurring at the start of the project). 

Required: Should NaCl ltd proceed with this project?

Answer rating: 100% (QA)

To determine whether NaCl ltd should proceed with this project we need to calculate the projects net ... View the full answer