You are helping Initech with its capital budgeting decisions. The company is a producer and wholesaler of electronic parts, has a 14% cost of capital and is subject to a 30% tax rate. There are two major proposals on which Initech would like your advice.
Building rental, fixed salaries and other fixed costs directly related to the project are expected to be $1,500,000 in the first year and increase by 2% per year thereafter. The investment in net operating working capital related to the project is expected to be 10% of the following year’s sales revenues. This investment will be recovered by the end of the project. It is also thought that the project will encourage additional after tax profits of $150,000 per year for Initechs’ existing part range.
Initech needs to install a conveyer system as soon as possible because the existing system, which has no scrap value, is beyond repair. Three different systems are being considered. The first, System A, is the same type of system as the old one – just a newer model. It will last 10 years and cost $40,000 to purchase and install. The second, System B, will last 10 years and cost $55,000 to purchase and install. The third, System C, will last 20 years and cost $130,000 to purchase and install. None of the systems will have any expected salvage value but all will be replaced at the end of their lives. After examining all costs, the net cash outflows for each system are: $13,000 per year for System A; $9,000 per year for System B; and $1,400 per year for System C.
For this question you are required to further analyse the ASX listed company assigned to you for Assignment
a) Briefly describe a likely “average” risk capital budgeting project for the company. Consider its possible life, cash flow pattern and investment size relative to the company. Also hypothesise the variables to which NPV might be most sensitive and would therefore need the most focus in project analysis. No quantitative analysis is needed to answer this question. Focus on qualitative factors. If the company has several business divisions, choose one for this question.
No additional research or data is necessary in answering this question. Simply apply your knowledge from the unit learning materials.
Our commercial paper is used principally to support working capital and short term liquidity.
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