As the Chief Financial Officer for the wholly Australian owned, Australian Stock Exchange listed company, Toy Show Ltd., an importer and manufacturer of a range of quality children's products sold throughout Australia, you have recently undertaken an evaluation of 2 mutually-exclusive machines that could assist the company in meeting its demand for the production of dolls houses. One of the machines is sourced from Germany and has a four-year expected life and the other is from Australia and has a six-year expected life. Each machine could comfortably cope with current and anticipated future production volumes for its premium dolls house lines.
You are now in the process of bringing together the capital budgeting information collected and preparing your final recommendations to be presented to the Board of Directors of the company at a special meeting that has been called to discuss your results and recommendations. Having had experience in making such presentations in the past to the current Board, you are aware that none have any extensive finance skills. As a result, it is important to provide any discussion in a manner that incorporates appropriate technical terms where relevant, but should where possible, use language that is clear and not presume any significant finance background.
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The capital budgeting details prepared to date regarding the alternative machines are shown in the table below: Purchase price
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Before-tax Present value of product sales
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After-tax Present value of product sales
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Before-tax Present value of operational costs
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After-tax Present value of operational costs
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German machine
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$3.1 million
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$27 million
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$21.5 million
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$20 million
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$16 million
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Australian machine
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$4.2 million
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$38 million
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$29.9 million
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$29 million
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$23 million
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In addition, you have collected the following current information about the company: Current share price:
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$12
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Number of shares on issue:
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2,500,000
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Current weighted average cost of capital:
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14.5%
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a) i) Why should your analysis of this capital budgeting proposal be undertaken on a before-tax basis?
ii) In the context of the question provide some thoughts as to why the machines subject to evaluation are stated to be "mutually-exclusive.
b) i) Calculate the appropriate (before-tax) net present value (NPV) of both the German and Australian sourced machines.
ii) Briefly explain why the NPV calculated above is not sufficient to make a selection between the 2 mutually-exclusive machines for capital budgeting purposes.
c) i) Calculate the appropriate value of both the German and Australian sourced machines based on the Equivalent Annual Annuity (EAA) approach. Include a brief explanation of the processes used for each calculation and an interpretation understandable to the Board as to what each calculation represents.
ii) Make a capital budgeting selection of either the German or Australian sourced machine based on your calculations in part c) i) of this question. Briefly justify your response.
d) i) Having made your capital budgeting selection, why would this financial decision be expected to impact on the company's share price? Briefly justify your response.
Note: No calculations are required for this part of the question - only a statement as to the expected direction of the share-price movement is required with a justification as support for your response.
ii) Following your discussion in part d) i) of this question, when would it be expected that a movement in the company's current share price would occur? Briefly justify your response.
iii) Given your statements in parts d) i) and ii) of this question, showing all calculations, what would be the amount of the expected change in the company's current share price and what is the anticipated new share price after this change? Briefly justify your response.
iv) In your opinion, why in practice is it likely that the actual fluctuation in the share price will be different from that calculated in part d) iii) of this question? Provide an explanation that could be used to present to the Board of Directors of the company.