Question
A firm called DD is considering an investment proposal to expand one of its product lines. Following information is available.
|
YEAR (t)
|
STOCK MARKET INDEX (Xt)
|
DD's SHARE PRICE (Yt)$
|
SALES
(units)
|
|
1990
|
2,005
|
5.00
|
500,000
|
|
1991
|
2,201
|
5.50
|
550,000
|
|
1992
|
2,410
|
5.75
|
540,000
|
|
1993
|
2,520
|
5.90
|
560,000
|
|
1994
|
2,602
|
6.00
|
565,000
|
|
1995
|
2,835
|
6.10
|
590,000
|
|
1996
|
2,650
|
6.00
|
600,000
|
|
1997
|
2,502
|
5.90
|
610,000
|
|
1998
|
2,854
|
6.50
|
615,559
|
|
1999
|
3,210
|
7.00
|
669,000
|
|
2000
|
3,420
|
7.25
|
700,000
|
Capital outlay for the proposed project:
- at the beginning of first year $1.5 million
- at the end of the third year (upgrade) $0.7 million
The economic life of the proposed project is 8 years.
The level of working capital for the project:
|
Year
|
0
|
1
|
2
|
3
|
4
|
5
|
6
|
7
|
8
|
|
Working Capital
|
2,100
|
2,600
|
3,200
|
3,700
|
4,100
|
4,500
|
4,000
|
3,500
|
0
|
At the end of the 8th year, the salvage value of the (2.2 million) capital outlay is $25,000. The depreciation rate for the initial investment, for tax purposes, is 12.5% per annum. The upgrade is allowed $140,000 depreciation per year for years 4 through 8.
The investment analyst has decided to forecast the sales (units) by using time-trend projections. These are to be adjusted from year 4 onwards to account for the increased sales resulting from the upgrade, which is estimated as 0.5 million units per year. Product price is expected to be 55 cents per unit for the first five years, and 80 cents thereafter. Production cost is estimated to be 12 cents per unit. Other operating costs (which does not include depreciation) are $55,000 per year for the first five years and $60,000 per year for the rest of the project life.
Company tax rate is 34%
Government bond yield is 6%
The managers believe that the degree of risk of the proposed project is basically the same as that of the existing business' risk. The analyst would like to use a risk-adjusted discount rate calculated by employing the CAPM.
Required:
Calculate the Accounting Rate of Return (ARR), payback period, NPV and IRR. ARR has many variants and you are required to define your method used for your calculation.