Question 1c
The Board of OAP Co has decided to limit investment funds to $10 million for the next year and is preparing its capital budget. The company is considering five projects, as follows:
| Initial investment | Net present value | |
| Project A | $2,500,000 | $1,000,000 |
| Project B | $2,200,000 | $1,550,000 |
| Project C | $2,600,000 | $1,350,000 |
| Project D | $1,900,000 | $1,500,000 |
| Project E | $5,000,000 | To be calculated |
All five projects have a project life of four years. Projects A, B, C and D are divisible, and Projects B and D are mutually exclusive. All net present values are in nominal, after-tax terms.
Project E
This is a strategically important project which the Board of OAP Co have decided must be undertaken in order for the Company to remain competitive, regardless of its financial acceptability. Information relating to the future cash flows of this project is as follows:
| Year | 1 | 2 | 3 | 4 |
| sales volume (units) | 12,000 | 13,000 | 10,000 | 10,000 |
| selling price ($/units) | 450 | 475 | 500 | 570 |
| variable costs ($/unit) | 260 | 280 | 295 | 320 |
| fixed costs ($000) | 750 | 750 | 750 | 750 |
These forecasts are before taking account of selling price inflation of 5•0% per year, variable cost inflation of 6•0% per year and fixed cost inflation of 3•5% per year. The fixed costs are incremental fixed costs which are associated with Project E. At the end of four years, machinery from the project will be sold for scrap with a value of $400,000. Tax allowable depreciation on the initial investment cost of Project E is available on a 25% reducing balance basis and OAP Co pays corporation tax of 28% per year, one year in arrears. A balancing charge or allowance is available at the end of the fourth year of operation.
OAP Co has a nominal after-tax cost of capital of 13% per year.
Required:
(c) Discuss the reasons why the Board of OAP Co may have decided to limit investment funds for the next year. (6 marks) (25 marks)