Managerial Finance Learning/Assessment Task 2: Project Evaluation 2015.

Eclipse Ltd, an Australian manufacturer of Scientific Equipment, is considering expanding its Australian operation into producing Smart Phones. The Chief Financial Officer (CFO) of the company, Shelley Shores, believes there will be significant opportunities for growth for the company in the Smart phones market and is therefore looking to construct a new manufacturing plant in West Melbourne. Eclipse Ltd has not manufactured Smart Phones before but they have extensively researched the market and believe they can compete successfully.

     For this expansion Miss Shoreshas two options. The first option, Plant A, is a highly automated process that involves significant capital outlays but has lower running costs. Plant B is a more labour intensive facility that has lower initial capital outlays but higher running costs. Plant A and Plant B are mutually exclusive projects.  As Miss Shores’ assistant you have been asked to prepare an analysis of the projects to enable her to make a recommendation to the board of directors. To assist your evaluation Miss Shoreshas provided you with the following information:

 

1. Sales for Plant A Smart Phones amount to 150,000 units per year, starting next year, with sales increasing in line with economic growth. Sales for Plant B Smart Phones amount to 104,000 units per year, starting next year, with sales increasing in line with economic growth.
2. The Plant A Smart Phones has a selling price of $290 next year, increasing in line with inflation. The Plant B Smart Phones has a selling price of $384 next year, increasing in line with inflation.

• The nominal economic growth rate is projected to be 6% per year.

5. Plant A is expected to remain in operation for 6 years. Plant B is expected to remain in operation for 5. In the final year of each project the machinery will be sold for 35% of its initial value.  The land and buildings will be retained by the company.
6. Last year, Eclipse Ltd. paid Mac Bank $500, 000 for a feasibility study that confirmed the manufacturing expansion was economically viable.
7. The machinery is considered depreciable for tax purposes and will be depreciated using a diminishing value which is twice that of the straight-line value per year. The land, buildings and furnishings are not depreciable for tax purposes.

• Plant A will require a provision of $4,800,000 in working capital and Plant B will require a provision of $3,500,000 in working capital. These requirements will remain unchanged over the life of the plants.
• There will be additional Sales and Marketing expenses if the project goes ahead. Annually, Project A will incur $2,000,000 and Project B will incur $3,000,000. These annual costs will increase with inflation.

1. Head Office expenses will not increase. However, a fixed allocation of $360,000 per year will be charged to whichever project goes ahead.
2. All operating expenses are expected to remain constant.
3. Eclipse Ltd. is subject to a tax rate of 30%. Tax is paid in the same yearit is incurred. [Do not make any other assumptions about the company’s tax liability.]

• Both proposals are considered not to be in line with the company’s core business and are of different risk. Eclipse Ltd.’s nominal WACC is 10% (after tax).  The realWACC used by the Smart Phone industry is 12.62% (after tax).
• Inflation is projected to be 3% per year for the period of each investment.

 

Other information:

Plant A		Plant B
Initial Costs:*      Land *      Buildings *      Machinery *      Furnishings and fittings	$12,500,000 $80,500,000 $26,150,000 $3,459,000	Initial Costs:*      Land *      Buildings *      Machinery *      Furnishings and fittings	$8,500,000 $60,050,000 $10,150,000 $2,459,000
Operating expenses:*      Fixed costs *      Variable costs per unit *      Labour costs per unit	$900,000 $21.80 $14.20	Operating expenses:*      Fixed costs *      Variable costs per unit *      Labour costs per unit	$700,000 $35.80 $25.00

 

Required:

1. Calculate the NPV, Non-discounted Payback, ARR and the IRR of Plant A and Plant B.

Interpret your results and offer your recommendations to Miss Shores.  If relevant, state any assumptions you have made.                                                                                                                                                                                                                                                                      10 marks

1. How may Eclipse Ltd identify the major risks that threaten the success of this investment project?  Use examples to illustrate how the company would seek to manage such risks.                                                                                                                                                                            3 marks
2. In an essay of no less than 500 words and no more than 800 words, discuss whether Eclipse Ltd in this instance, would be able to take advantage of a market that is less than perfectly efficient.  Illustrate your answer by giving examples.                                                                                                                                                                                                                                                    7 marks

 

 

Assessment Criteria:

Learning Outcomes	Possible Marks
Appraise and compare investment projects using investment evaluation techniques Show an understanding of the discounted cash flow method of asset valuation	10 marks
Assess the information exchange effect of a corporation and the market Show an understanding of the application of the Efficient Market Hypothesis	10 marks

 

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