Equator Ltd, an Australian manufacturer of laptop computers, is considering expanding its Australian operation into producing tablet computers. The Chief Financial Officer (CFO) of the company, Miss Mandy Morris, believes there will be significant opportunities for growth for the company in the tablet computer market and is therefore looking to construct a new manufacturing plant in North Sydney. Equator Ltd has not manufactured tablet computers before but they have extensively researched the market and believe they can compete successfully.
For this expansion Miss Morrishas two options. The first option, Plant A, is a highly automated process that involves significant capital outlays but has lower running costs. Plant B is a more labour intensive facility that has lower initial capital outlays but higher running costs. Plant A and Plant B are mutually exclusive projects. As Miss Morris's assistant you have been asked to prepare an analysis of the projects to enable her to make a recommendation to the board of directors. To assist your evaluation Miss Morrishas provided you with the following information:
i) Sales for Plant A tablet computers amount to 155,000 units per year, starting next year, with sales increasing in line with economic growth. Sales for Plant B tablet computers amount to 95,000units per year, starting next year, with sales increasing in line with economic growth.
ii) The Plant Atablet computerhas a selling price of $320 next year, increasing in line with inflation. The Plant B tablet computer has a selling price of $440 next year, increasing in line with inflation.
iii) The nominal economic growth rate is projected to be 5.5% per year.
iv) Plant A is expected to remain in operation for 6years. Plant B is expected to remain in operation for 5. In the final year of each Plant,the machinery will be sold for 33% of its initial value. The land and buildings will be retained by the company.
v) Last year, Equator Ltd. paid MacBank $320,000 for a feasibility study that confirmed the manufacturing expansion was economically viable.
vi) The machinery is considered depreciable for tax purposes and will be depreciated using a straight line depreciation method down to its salvage value. The land, buildings and furnishings are not depreciable for tax purposes.
vii) Plant A will require a provision of $3,500,000 in working capital and Plant B will require a provision of $4,800,000 in working capital. These requirements will remain unchanged over the life of the plants.
viii) There will be additional Sales and Marketing expenses if the project goes ahead. Annually, Project A will incur $1,900,000 and Project B will incur $2,800,000. These annual costs will increase with inflation.
ix) Head Office expenses will not increase. However, a fixed allocation of $350,000 per year will be charged to whichever project goes ahead.
x) All operating expenses are expected to remain constant.
xi) Equator Ltd. is subject to a tax rate of 30%. Tax is paid in the same yearit is incurred. [Do not make any other assumptions about the company's tax liability.]
xii) Both proposals are considered not to be in line with the company's core business and are of different risk. Equator Ltd.'s nominal WACC is 13%. The realWACC used by the Computer Tablet industry is 13.35%.
xiii) Inflation is projected to be 3.5% per year for the period of each investment.
Other information:
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Plant A
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Plant B
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Initial Costs:
* Land
* Buildings
* Machinery
* Furnishings and fittings
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$11,650,000
$82,000,000
$26,150,000
$3,200,000
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Initial Costs:
* Land
* Buildings
* Machinery
* Furnishings and fittings
|
$11,650,000
$59,500,000
$10,150,000
$2,980,000
|
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Operating expenses:
* Fixed costs
* Variable costs per unit
* Labour costs per unit
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$600,000
$21.80
$14.20
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Operating expenses:
* Fixed costs
* Variable costs per unit
* Labour costs per unit
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$800,000
$35.80
$25.00
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Required:
1. Calculate the NPV, Non-discounted Payback, and the IRR of Plant A and Plant B. Interpret your results. (If relevant, state any assumptions you have made.)
2. Describe and analyse 4 keys risks associated with the project you recommend (Project A or B).
3. Briefly define an ‘efficient' capital market. To what extent is Equator's ability to borrow funds in the capital market dependent upon the capital market operating in an efficient manner? (Your answer should be between a minimum of 500 words and a maximum of 600 words.)