OSIM is currently planning to launch a new massage chair. They have been doing research on this product for the past 2 years and have spent $2.5 million on R & D. They have also conducted market test of this product in Singapore and China at a cost of $2 million. The chairs will be ready to roll out by June 2013. The chairs will be priced at $6,500 each. The sales forecast for the next 4 years are shown below. OSIM believes that the life of this chair will be four years and by then a new modified chair will be introduced.
|
Year
|
Sales (Number of Chairs)
|
|
2013
|
- 1,500
|
|
2014
|
- 2,500
|
|
2015
|
- 3,000
|
|
2016
|
- 3,500
|
The cost of sales is estimated as 60% of sales. Other expenses will be $500,000 a year. This project will require investment in equipment of $12,000,000. The working capital requirement for this project is 25% of next year sales and at the end of 4 years, the total amount of working capital will be recouped. The equipment will be depreciated on a straight line basis over a 5 year period and the estimated salvage value at the end of 4 years is $3,500,000. Introduction of this new chair will reduce the cash flow from the existing products by $5 million every year.
The risk free rate is 2.5% and the market risk premium is 7%. The beta of OSIM is 1.5. Assume a tax rate of 20%.
Question 1
(a) Calculate the cost of equity and the weighted average cost of capital for the company. Assume that the cost of bond is 4% and the debt ratio is 30%.
(b) Which of these costs of capital, cost of equity or weighted average cost of capital, should be used to discount the new project? Analyse your rationale for using this cost of capital.