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NPV and lease payment calculations for new project

Click Inc. is considering investing in a new project to produce and sell clips. New machinery costing $1 million in total will be required and the machines are expected to have a resale value of $450,000 at the end of the project's five-year life.

Sales of clips, all at $5 each, are forecast to be as follows:

Year Units
1 100,000
2 120,000
3 156,000
4 109,200
5 65,530

Each clip will take 15 minutes to produce. Labour and associated overheads currently cost $5 per hour and this hourly rate will increase by 3% per annum, after the end of year one. Each clip uses $1 of raw material in year one. The price of raw materials is expected to increase by 5% per annum after the end of year one.

It has been decided that annual fixed overheads, which will not change, will be allocated by head office at 10 pence per clip ($0.1 each). Click Inc. will depreciate the machinery over its five-year life, using straight-line depreciation.

The cost of capital (discount rate) to be used for this project is 15% per annum. Assume that all cash flows occur at the end of each year, except for the initial purchase of the machinery, which will be incurred at the start of the project (at T0). Ignore taxation for the purposes of your calculations.

Provide the following calculations:

a) Calculate the NPV of the project and advise Click's managers whether they should proceed with it. What other factors might they want to take into consideration, apart from your calculations?

b) If Click Inc. could lease the machinery needed for production of the clips, for five equal payments, commencing immediately (at T0), what is the maximum annual lease payment that the company should be prepared to pay? What other factors might influence this decision?

c) Is it advisable to reduce the selling price for clips from the end of year three, in order to try to increase sales? Discuss what factors would need to be considered in this context. No further calculations are necessary.

Solution Summary

NPV and lease payment calculations for new projects are examined.