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Question 1 (49 marks) Caribbean Manufacturers Ltd (CML) wants to invest in a new machine to start producing cocoa chips

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Question 1 (49 marks)

Caribbean Manufacturers Ltd (CML) wants to invest in a new machine to start producing cocoa chips. The purchase price of the new machine is $6,750,000 which will have an economic life of five years. A working capital of $750,000 is required at the beginning of the project and this is estimated to increase by 4% of the previous year’s amount annually. Management is anticipating the production of 850,000 bags of chips for the local market annually.

As a result of limited production capacity, the entity anticipates that there will be a decrease in the production of its famous dasheen chips by 5%. Annual production of the dasheen chips were 100,000 units at a unit selling price of $80 and unit variable cost of $60. Fixed production cost will not be affected by the reduction in output. Each bag of cocoa chips will be sold for $120 and will cost $80 to produce. A previous market research has indicated that CML could gain 14% of the market in the first three years and 10% in the final two years.

Other relevant information are as follows:

1)Variable distribution cost of $3 each

2)Annual promotion cost of 2% of sales revenue

3)Depreciate the machine using the straight-line method. There is no residual value.

4)It is estimated that the working capital will be recovered at the end of the project.

5)The required rate of return on debt is 20% and return on equity is 14%

6)Currently the assets of the company are funded by 60% debt and 40% equity

7)Corporation tax rate is 30%.

*** Depreciation is an allowable deduction for tax purposes.

Required:

(a) The annual operating income after tax and the operating cash flows of the project and the net present value (NPV). (34 marks)

(b) Internal Rate of Return and Profitability index of the project. (7 marks)

(c) A Recommendation to the management team to accept or reject the project. (2 marks)

(d) Discuss three (3) factors that the entity can consider when implementing this project?

(6 marks)