The directors of Woodcote Range Co., a listed company, are planning to meet market demand for its products by purchasing new machinery costing $3.5 million. The project name is ‘Growth’. The machinery would last for five years, at the end of which it would be replaced. The scrap value of the machinery is expected to be 5% of the initial cost. Capital allowances would be available on the cost of the machinery on a 25% reducing balance basis, with a balancing allowance or charge claimed in the final year of operation. This investment will increase production capacity by 10,000 units in the first year, increasing by a further 5% per year for years 2 to 5. 

Relevant financial information in current price terms is as follows: 

- Selling price $450 per unit with inflation 3.5% per year. 

- Variable cost $275 per unit with inflation 4% per year. 

Production departments take a share of existing overheads to the sum of $575,000 per annum and the project will generate incremental overheads of $300,000 per annum both quoted in current prices. Inflation of 6.0% per year applies to overheads. 

The machinery will also require the use of warehouse space which is currently being rented out and earning rental income of $120,000 per annum in current terms. The rental income is due to increase by 1.5% per annum. This income will be foregone if the project goes ahead. There will be working capital requirements of $500,000 at the outset. This amount will be released in full at the end of the project. Woodcote Range Co. pays tax on profits at the rate of 20% per year, one year in arrears. The company has a nominal (money terms) after-tax cost of capital of 15% per year. 2 Required You have been asked to produce a report for the directors of Woodcote Range Co. to include the following:

1. A calculation of: a) the net present value of project Growth using a nominal (money terms) approach; and b) the payback period for project Growth. A detailed analysis showing how the NPV and payback period have been calculated should be included as an appendix to the report, together with any assumptions and related calculations.

2. Advice to the directors of Woodcote Range Co. on the viability of the proposed investment, and a summary of non-financial factors that the directors should consider before finalizing their decision. Your advice should include an evaluation of the benefits and disadvantages of the two appraisal methods used.

3. A discussion and critical evaluation of the theory that Financial Management involves determining an optimum capital structure. You should refer to relevant models and theories to support your work.

Answer rating: 100% (QA)

1 a To calculate the net present value we need to discount the cash flows at the aftertax cost of capital The cash flows are as follows Year 0 3500000 initial investment Year 1 1200000 increase in sal... View the full answer