Capital Budgeting-5 page

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5 -page

Assume that you
are an adviser at LATECH Ltd, which is analysing the introduction of a
new game console named NEUROPOWER. This system can be connected with
human brain functions, and is still very much controversial for claimed
but yet to be confirmed adverse impacts on human behaviour after
prolonged application. Health conscious groups are also lobbying against
introduction of such games with probable detrimental effects.

Project Manager of LATECH Ltd needs a detailed analysis of this
exciting NEUROPOWER project. She comes into your office, drops a
consultant’s report on your desk, and complains, ‘We paid these
consultants $1 million for this report, and I am not sure their
financial analysis makes sense, though their estimations seem to be
correct. Before we spend $60 million on buying new equipment needed for
this project, look it over and give me your opinion.’ You open the
report and find the following information and estimates:

project will continue for the next seven years, and by that time more
reliable information on possible adverse impacts of using NEUROPOWER
will be available. It is projected that equipment will have an economic
life of 10 years. After buying the equipment, it requires renovation of
the production bay at LATECH Ltd and installation of the equipment at a
total cost of $2 million. These renovation and installation costs are to
be considered as capital expenditures. A staff training cost of
$200,000 is to be incurred initially at the start of the project.

equipment will be procured from Germany and LATECH Ltd has to pay 8%
import duty on purchase price, whereas the supplier will pay
transportation costs of $90,000. These property, plant and equipment
(PPE) would be depreciated over their useful life of 10 years using a
tax allowable straight line rate of 10%. However, the company is
planning to sell the equipment at the end of the project for an
estimated price of $12 million.

Consultants estimate that 96,000
NEUROPOWER consoles can be sold in the first year with an expected
increase by 25% in each year for the next two years; afterwards, sales
are expected to decrease by 20% in each year until the end of the
project, due to a number of actions by the competitors in the market.
Annual fixed operating cost, excluding depreciation, will be $1 million.
Variable operating costs will be 50% of sales. Beginning selling price
per console will be $500, which will be dropped by 10% in the fourth
year for the rest of the project life.

Existing facilities to be
used for the NEUROPOWER project are coming from another production line
that earns net $21,000 per month. That production line will be
discontinued on the commencement of the NEUROPOWER project. For the
duration of the project, LATECH is also planning to take the service of a
market analyst at a cost of $9,000 per month.

It is also
estimated that the new production line will require an initial increase
in investment for $970,000 in stock (inventories) and $910,000 in
debtors (accounts receivable) that are offset by an increase in
creditors of $480,000 (accounts payable). There will be no further
investment in net working capital (NWC) until its final recovery at the
end of project life.

The company uses required rate of return
considering its weighted average cost of capital (WACC) that varied from
16% to 22% in recent times. The analyst is confused about the rate to
be effective for the project; however, she has decided to use 16%
required rate to evaluate this project. Corporate tax rate is 30%. The
required discounted payback period is five years.

The Project
Manager hesitates to take the final decision because of unexpected
growth in the game industry, with technological advancement in different
directions. As an alternative, LATECH has an offer to introduce an
upgraded version of a safe traditional game console, the IQFORCE.
Initial total investment for this IQFORCE project would be the same as
the NEUROPOWER project and projected net future cash flows (after all
adjustments) would be as follows:

Year 1: $30,400,000; Year 2: $29,200,000; Year 3: $19,700,000;

Year 4: $17,500,000; Year 5: $15,200,000; Year 6: $10,000,000;

taking the final decision in the upcoming meeting, the Project Manager
of LATECH Ltd requires a clear explanation of all relevant issues
relating to the NEUROPOWER project. Particularly, a formal report is
enquired by the Project Manager to include a detailed analysis of cash
flows and explanations of results of capital budgeting methods that are
commonly used in evaluating projects. Furthermore, in a separate section
in the report, the Project Manager is interested in reviewing a
detailed comparison between the NEUROPOWER and IQFORCE projects, with
regard to the results of applicable capital budgeting methods using both
16% and 22% required rates, crossover rate and all relevant factors
that can assist in taking the final decision.

Your assignment will require the following:

an Excel spreadsheet, prepare a full analysis to be presented to the
Project Manager of LATECH Ltd to assist in evaluating whether either
project should be started or not.

Your analysis should include
the following: table of cash flows (show all digits, do not convert
amounts to $ in million or thousand) use of Excel formulae where
appropriate a written report (1500 words, +/- 10%) outlining your
recommendation as to whether LATECH Ltd should proceed with either

Justify your recommendations using quantitative and
qualitative issues, and your analysis of probable risks and benefits
relating to the project. Comparison statement is to be presented in a
separate section in the report. You will submit the following documents:

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