PART C

Synapsing Limited is contemplating an investment in equipment which will enable it to increase production in its neurotransmitter range. The equipment, which has a 5-year life for depreciation purposes, is currently available at a price of $1 million. Preliminary financial analysis has been undertaken and the details are as follows:

• Revenue at the end of the first year is estimated to be $1,080,000 and this is expected to increase by 5% per year.

• Cost of sales will be to 63% of revenues each year.

• Fixed cash expenses are estimated to be $110,000 per year.

• Synapsing has spent $50,000 on researching this investment over the last 12 months.

• Maintenance costs on the equipment will be $28,000 at the end of the first year and are expected to increase by 10% per year as the equipment ages.

• Depreciation is based on the purchase price of the equipment. The equipment is expected to have a cash scrap/salvage value of $100,000 at the end of 5 years and depreciation should be calculated on a straight-line basis to a book value of $100,000 at the end of year 5.

• Tax on profits is calculated at a rate of 30% and tax is paid at the end of each year.

• Working capital of $200,000 is required to support production and needs to be raised at the beginning of the investment. This is fully recoverable at the end of the 5-year period.

• There are no plans to invest in new equipment at the end of 5 years, and as such, the analysis should be conducted over a 5-year investment horizon.

• The hurdle rate (cost of capital) for investments of this type is 10%.

• Income and expense items should be recognised at the end of the year in which they occur.

• Inflation is low and for the purposes of this analysis should be considered to be zero.

Required

1. What is the net present value (NPV) and internal rate of return (IRR) for the proposed investment? Should it proceed?

2. What minimum annual growth rate in revenue is required for this investment (1 decimal place please)?

3. Returning to the original data, you have heard that the vendor of the equipment may be willing to negotiate on price. What is the maximum price at which you can negotiate for the purchase given the information provided in the dot points above?

4. Returning to the original data, suppose you can make an additional investment of $100,000 in a new technology that will enable the same level of production but with a lower cost of sales and less working capital. The technology can be amortised straight-line over 5 years. You estimate that the cost of sales will fall to 60% of revenue is this investment is undertaken. How much will working capital need to fall to in order for the investment to be worthwhile?