Synergy is now considering a project to launch a new product called M1. The life of the project is expected to be six years, and the projects risk is similar to that of the companys existing operations. To manufacture M1, a new machine costing $1,200,000 will be required. The machine will be sold at the end of the project, and a $42,000 salvage value is expected. Production and sales of M1 are expected to be 100,000 units in the first year, 110,000 units in the second year, 120,000 units in the third year, and 125,000 units in each of the remaining three project years. Variable costs of $12 will be incurred for each unit, which can be sold for $19. Incremental fixed cost amounting to $300,000 per year will also be incurred. Working capital investment required at the beginning of the project is estimated to be 15% of the expected sales revenue in the first year of the project. Thereafter, Synergy will review working capital requirement at the end of each year to determine if the existing level of working capital investment requires adjustment. In each review, the level of working capital investment considered appropriate will always be 15% of the expected sales revenue in the next year. (For example, in the first review, which will take place at the end of the first year, the level of working capital investment considered appropriate will be equal to 15% of the expected sales revenue in the second year of the project).

The project is expected to use a factory building owned by Synergy. The building is currently unoccupied but recently the company received an offer to rent the building for $55,000 a year for six years. The rental income will not be taxable as it is exempted under a government scheme aimed at encouraging companies to rent out unused factory space. The risk-free rate is 2.5% per year and the expected return on the market is 10% per year. The company pays profit tax in the same year at an annual rate of 20%. Tax allowable depreciation should be ignored.

(1)Evaluate the M1 project using the net present value method and recommend to Synergy whether the project should be launched.

(2)Explain how Synergy could use sensitivity analysis to assist the evaluation of the M1 project. Estimate the two sensitivities below and use them as illustrative examples in your explanations. i) The sensitivity of the M1 project to M1s unit selling price. ii) The sensitivity of the M1 project to the incremental fixed cost.

(3)Synergy would also like to understand more about the limitations of the internal rate of return (IRR) method. Please explain.