Question 1

Zetatron Berhad: Project Evaluation

It has been two months since you took a position as an assistant financial analyst at Zetatron Berhad. Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves both the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects. Given your lack of tenure at Zetatron Berhad, you have been asked not only to provide recommendation, but also to respond to several questions aimed at judging your understanding of the capital-budgeting process. The memorandum you received outlining your assignment follows:

To: The Assistant Financial Analyst

From: Mr. Morrison, CEO Zetatron Berhad

Re: Cash Flow Analysis and Capital Rationing

We are considering the introduction of new product. Currently we are in the 24% tax bracket with a 15% discount rate. The project is expected to last five years and then, it will be terminated. The following information describes the new project:

Cost of new plant and equipment RM 7,900,000

Shipping and installation costs RM 100,000

Unit Sales:

Year	Units Sold
1	70,000
2	120,000
3	140,000
4	80,000
5	60,000

Sales price per unit: RM300/unit in Years 1-4 and RM260/unit in Year 5

Variable cost per unit: RM180/unit

Annual fixed costs: RM200,000 per year

Working capital requirements:

There will be an initial working capital requirement of RM100,000 just to get production started.

Depreciation Method:

Straight line over five years assuming the plant and equipment have no salvage value after five years.

Required:

a) Why should Zetatron Berhad focus on project free cash flows as opposed to the accounting profits earned by the project when analyzing whether to undertake the project?

b) What are the incremental cash flows for the project in Year 1 through 5, and how do these cash flows differ from the accounting profits or earnings?