finance :npv and irr

FoneBuzz Ltd, anAustralian manufacturer of lightweight tablet computers, is considering expandingits Australian operation into producing tablet computers. The Chief FinancialOfficer (CFO) of the company, Ms Michelle Smith, believes there will besignificant opportunities for growth for the company in the tablet computermarket and is therefore looking to construct a new manufacturing plant inSydney. FoneBuzz Ltd has not manufactured tablet computers before but they haveextensively researched the market and believe they can compete successfully.  For this expansion Ms Smith has two options. The first option,Plant A, is a highly automated process that involves significant capitaloutlays but has lower running costs. Plant B is a more labour intensivefacility that has lower initial capital outlays but higher running costs. PlantA and Plant B are mutually exclusive projects. As Ms Smith’s assistant you have been asked to prepare an analysis ofthe projects to enable her to make a recommendation to the board of directors.To assist your evaluation Ms Smith has provided you with the followinginformation:i) Sales for Plant A tablet computers amountto 145,000 units per year, starting next year, with sales increasing in linewith economic growth.  Sales for Plant B tabletcomputers amount to 78,000units per year, starting next year, with sales increasing inline with economic growth.  ii) The Plant A tablet computer has aselling price of $300 next year, increasing in line with inflation.  The Plant B tablet computer has a sellingprice of $460 nextyear, increasing in line with inflation.iii) The nominal economic growth rate isprojected to be 5% per year.iv) Both proposals are expected to remainin operation for 5 years. At the end of the fifth year the machinery will besold for 15% of its initial value.  The landand buildings will be retained by the company. v) Last year, FoneBuzz Ltd. paid MacBank $120,000 for a feasibility study that confirmed the manufacturing expansion waseconomically viable.  vi) The machinery is considered depreciablefor tax purposes and will be depreciated using a straight line depreciationmethod down to its salvage value. The land, buildings and furnishings are notdepreciable for tax purposes.vii) Plant A will require a provision of ($2,015,000)in working capital and Plant B will require a provision of ($3,015,000) inworking capital. These requirements will remain unchanged over the life of theplants.viii) There will be additional Sales andMarketing expenses if the project goes ahead. Annually, Project A will incur $350,000and Project B will incur $2,000,000.  ix) Head Office expenses will notincrease.  However, a fixed allocation of$150,000 per year will be charged to whichever project goes ahead.x) All operatingexpenses are expected to remain constant.xi) FoneBuzz Ltd. is subject to a tax rate of30%.  Tax is paid in the year after it isincurred. [Do not make any other assumptions about the company’s tax liability.]xii) Both proposals are considered not to be in line with thecompany’s core business and are of different risk.  FoneBuzzLtd.’s real WACC is 8.60%. The nominal WACC used by the Computer Tablet industry is10%.  xiii) Inflation is projected to be 3% peryear for the five year period. Otherinformation:  Plant  A    Plant  B    Initial  Costs:  *  Land  *  Buildings  *  Machinery  *  Furnishings and fittings      $12,500,000  $84,050,000  $26,150,000  $3,459,000    Initial  Costs:  *  Land  *  Buildings  *   Machinery  *  Furnishings and fittings      $12,500,000  $71,050,000  $10,150,000  $3,459,000    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      $800,000   $35.80  $25.00  Required:Calculate     the NPV and the IRR of Plant A and Plant B; and explain whether the     ‘systematic risk’ of Plant A and Plant B has been priced into the     NPV.    10 marksExplain     whether the NPV and the IRR methods of project evaluation satisfy the     objective to maximise shareholder wealth.      To what extent does the NPV, and the IRR decision, depend on the     Capital Market operating efficiently?     10 marksAssessment 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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