The zither industry will have a rapid expansion in the next four years. With the brand name recognition that MHSB brings to bear, we feel that the company will be able to sell 3,200, 4,300, 3,900, and 2,800 units each year for the next four years, respectively. Again, capitalising on the name recognition of MHSB, we feel that a premium price of RM780 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued.
MHSB agrees to the suggested price for the first year but intends to raise it by RM20 each year. MHSB also believes that fixed costs for the project will be RM425,000 per year, and variable costs are 15 percent of sales for the first two years. Due to inflation MHSB expects that the variable cost per unit will increase to RM120 and RM123 for the third and fourth year, respectively. The equipment necessary for production will cost RM4.2 million and will be depreciated using the straight-line method down to zero by the end of the project period. However, MHSB estimates that the equipment will have a scrap value of RM250,000 at the end of the fourth year. Net working capital of RM125,000 will be required immediately, and thereafter, the working capital requirements will be at 5 percent of sales. MHSB has a 25 percent tax rate, and the required return on the project is 13 percent.
A. What is the project’s cash flow for each of the next four years?
B. What is the payback period? Based on your answer, would you recommend MHSB to invest in this project?
C. Compute the net present value of the project. Should MHSB proceed with the project? Why or why not?