Project Description
Due to the face mask sales during COVID-19, the Neqi firm, which creates and markets face masks, rose to the top of the list of profitable businesses. On a declining balance basis, its fixed overhead costs represent the factory’s current non-flexible expenses coupled with the capital allowance of 25%. One of Neqi’s recently established production lines is projected to run for five years on working capital of £ 0.5 million. The company intends to purchase equipment whose residual worth is £2 million and will remain static until the end of the project in order to properly run this new line of manufacturing, probably reusable face masks (The Guardian, 2020). One of the Neqi buildings, which was purchased three years ago for £6 million and has already depreciated to £2.5 million, will accommodate the new production line. The firm will contribute £ 3.5 million after tax-residual costs if this building is used in the proposed project for an additional 5 years. Only if the strategic department formulates a strong strategic plan to direct the company in decision-making will Neqi’s proposed project of operating a new production line be successful.
Strategic Department Forecasts
Neqi’s strategy department made a number of forecasts on expected inflation to create a strategic plan, including mask price (5% p.a.), direct project costs (3% p.a.), and fixed overhead costs (5% p.a.). For projects with a similar level of risk, Neqi’s true cost of capital is 8%. This corresponds to an inflation rate of 4.63% annually. The proposed project’s marginal tax rate is 30%. However, proper forecasting also depends on the project budget in addition to the predicted inflation.
Project Budget/Cost
The budget, mostly called cost, is the main parameter of a project. Inflation plays a pivotal role in surging project budgets. In addition to causing an increase in labor and raw material costs, inflation increases the prices of equipment needed, although, for the current case, existing equipment will be used. There are two aspects of costs associated with a project, namely nominal and real costs. As noted by Serra (2018), nominal cost refers to the present budget before accounting for economic dynamics such as inflation, while real cost is the cost brought by economic adjustments. Given the nominal cost of capital (13%) and an inflation rate of 4.63%, the real cost of the project is determined using Equation 1.
Irrelevance of Three Cash Flow Items
Research Fee
In launching a new product line, firms must set aside research funds. Costs associated with the research are always reflected in the strategic plan. However, there is no need for research in the current project because the whereabouts of the proposed product is known. This makes research costs irrelevant to the current project. Neqi’s continued engagement in the project is not supported by the wasted expenses incurred prior to project initiation.
Fixed Overhead Cost Per Unit
A strategic plan for launching a new product line must also account for overheads, especially fixed overhead costs. It includes property taxes (£3.5 million), rent, salaries or wages, government licenses, and asset depreciation (£2.5 million). The fixed overhead must be paid whether or not the project is accepted because it is connected to the current production level and does not represent any change linked to the project. Therefore, existing fixed costs or fixed overhead are irrelevant.
Property-Opportunity cost
To execute the project, Neqi is expected to forgo the option of selling its equipment and retain it for production in the next 5 years. Nonetheless, the cost of equipment has already depreciated by £2.5 million. Similarly, new production exploits an empty building that has been on the books for four years without being put to any beneficial use; there is no opportunity cost associated with the property, and by using it for production, no opportunity will be lost for any other useful purposes. Since the book value of the property represents already-incurred sunk costs, it is not relevant to the decision to undertake a project.
Assessing the Financial Viability of the Proposed Project
To assess the financial viability of Neqi’s project of producing new face masks using a cash flow model, it is ambient to determine its net present value (NPV). In this context, NPV refers to the difference between cash inflows and cash outflows over a given period. The viability of a project can also be determined in terms of its profitability. From a project profitability point of view, investors establish project financial viability by finding the accounting rate of return (ARR), particularly return on investment (ROI). Essentially, analysts focus on the money that is expected from the project and the return on the investment. Simply put, Neqi’s case is associated with a project working capital of £ 0.5 million, expected to yield more than £ 3 million.
The ROI calculated above indicates the possibility of the proposed project yielding more return than expenditure. Therefore, the project has the potential to be profitable. Using the calculated ROI of 600%, the project is classified as high-performing, which is likely to attract the attention of potential investors, donors, and sponsors.
References
Serra, R. G. (2018). Reconciling FCFF and FCFE in nominal and real models. SSRN Electronic Journal. Web.
Geddes, L. (2020). The face mask test: Which is the best at limiting the spread of Covid? The Guardian. Web.