The Comfort is based in the fictitious company of Painland and uses the Painland $ as its currency. It specialises in manufacturing and selling items used by people to massage areas of their bodies suffering from pain, including aching backs, strained muscles, and knee and ankle bone joints. It is currently considering investing in a new three-year (3-year) project. This project would manufacture and bring to market a new product called Pain Pod for use by people with lower back pain. The product will sell for $10 for each unit, based on price values ($) in 2021. This is a growing but competitive market and the company views the early launch of this project as being important in the context of establishing competitive advantage over market rivals. Thus far, the company has specialised in low volume, niche-market products and this is its first venture into high volume standard-type products.

The company has already spent $1 million on researching and developing the product and intends to start production and sales on 1 January 2022. The project will use part (50 per cent) of the company’s existing factory building. This part of the factory building is currently being used on a project which will finish on 31 December 2021. The entire factory building is currently rented at a cost of $1 million annually – as it has been for the past five (5) years, and this rent should not, at least in principle, increase over the life of the new project, although the rental agreement is to be reviewed by the factory owner on 31 December 2022. The new project will use existing equipment purchased on 1 January 2017 for $10 million. This equipment has already been fully depreciated with $zero residual value and has already benefited fully from taxation capital allowances. It is still in good working condition. (Assume annual taxation capital allowances are currently 25% on a reducing balance basis.) The new project will also require the purchase of a new piece of equipment in December 2021 for $12 million, with a useful production life of three (3) years, depreciated for accounting purposes on a straight-line basis, and with $1 million residual value on 31 December 2024, the end of its useful three-year (3-year) production life. The company anticipates being able to sell the rights to the manufacture and sales of the Pain Pod to another company in 2025 for $2 million, with the sale being concluded on 31 December 2025.

Projected annual sales are one (1) million units in each year of the project’s three-year operational life.

Variable costs are budgeted to be $5 for each unit. The project, as with each of the company’s projects, will receive an annual company overhead charge of $500,000 relating to the company’s existing fixed overheads. The project is likely to result in the company’s existing annual fixed overheads increasing by $1 million cash payments. The values for variable costs and incremental fixed overhead costs referred to immediately above are based on price values ($) in 2021.

Company taxation is 20% annually and is paid one year in arrears. (For ease of calculation assume that the 20% tax rate is applied to each annual figure ($) based on sales ($) minus variable costs ($) minus incremental fixed costs ($) associated with the project.)

The general annual inflation rate across the life of the project is forecast to be 5%. The sales price ($) of each unit is likely to be impacted by an annual inflation rate of 10% in each year. The variable cost ($) of each unit is likely to be impacted by an annual inflation rate of 10% in each of 2022 and 2023, after which the variable cost will stabilise. The incremental fixed overheads arising from the new project are likely to be impacted by an annual inflation rate of 10% in each year. The company is funded by a combination of ordinary shareholders’ equity, a fixed interest rate bank loan, and a semi-variable (floating rate) bank loan. Its weighted average cost of capital (WACC), as in November 2021 and unadjusted for inflation, is 9.5242% and will be impacted by the general inflation rate. (If adjusted for inflation, the resultant WACC applied for discounting purposes is rounded to the nearest whole % figure. For example, and for illustrative purposes only, 17.0098% would be rounded to 17%.) The company is aware that Painland’s central bank is concerned about what it perceives to be a high rate of general inflation and is keeping a watchful eye on interest rates.x

a) What is your initial view on the project if the NPV of this project is -33,83,026 and looking at other relevant aspects? How do we take into account of potential changes (economic circumstances changing, and increasing competition and consequential potential changes in relevant factors across the life of the project) into the CAPEX appraisal, as well as other risk factors? Make sure your answer includes: [65 marks] Answer should not exceed 1,250 words

• Understanding key managerial finance issues and their management.
• Balancing the drivers of using profit as a measurement of performance against the drivers of using cash, and assess financial performance

• Identifying and appraising investment opportunities, taking account of cost of capital and risk, including incremental cash flows and investment appraisal
• Identifying and evaluating sources of finance in the context of implications for capital structures and returns
  to shareholders
• Identifying and critiquing ways of returning value to shareholders
• Identifying and evaluating methods to value a firm.

Answer rating: 100% (QA)

The initial view on this project is not favorable as the NPV of the project is negative This means that the project would not generate enough cash inflows to cover the costs of the project In addition ... View the full answer