Alphagam Inc. decided to launch a production of augmented reality (AR) glasses. According to a well-known consulting company “Wain & Co.”, a global demand for AR glasses will be 1 million units in 2018 and it is going to grow by 20% annually. Since there is a few suppliers of AR glasses in the world, the price for the product will be 800$ in 2018 and will decrease by 10% annually, as new producers enter the market. Alphagam Inc. expects its market share to be 20% (in terms of revenue) forever, starting right after the project launch. There are two types of equipment available. Equipment 1 provides Alphagam inc. with 30% EBITDA margin. It requires $100 million investment in production facilities and $10 million more on its delivery and installation in 2017. The residual value of the equipment at the end of the project will be $10 million (use straight-line depreciation) and its market value will be zero. Equipment 2 provides 40% EBITDA margin. It requires total CAPEX of $150 million in 2017. The residual value of the equipment at the end of the project is $20 million (use straight-line depreciation) and it can be sold for $35 million. For any type of equipment, the company needs $10 million of cash reserves on its balance sheet for operating activity. Alphagam Inc. should also have inventories (10% of EBITDA). Net working capital should be turned into cash at the end of the project. AR Inc. is the only public company that is involved in that kind of business today. AR Inc. is all-equity financed and has 50% exposure to AR glasses business and 50% to software development. The beta for software development industry is 1.2, while the beta for AR Inc. is 1.4. The US treasury yield is 2% and market premium is 10%. The tax rate is 40%. The project will be all equity financed and will last for 5 years. The project is expected to start in 2018.
1. Determine an appropriate discount rate and state all necessary assumptions.
2. Build the cash flows for the project and decide, whether the company should accept the project based on NPV rule. What should be the market value of equipment 1 in 2022 for Alphagam inc. to be indifferent between these options?