Part A
The management team of Online Jeans Sales have just received a new proposal from one of the firm's marketing managers. The proposal outlines a new investment to create a Custom Finish Laboratory. Through the lab, online customers will be able to select an option to personalise their jeans in a range of finishes. This proposal was made following the completion of market research costing $100,000.
The capital cost to establish the Custom Finish Lab will be $1,650,000. This cost will depreciated on the straight-line basis to zero over the 8 year productive life of the lab. It is estimated $100,000 will be recovered at the completion of the project as the salvage value of the lab.
In the first year of operations, the new lab is expected to increase the firm's revenues by $1,445,000. In addition to depreciation, the costs to run the lab will include additional staff costs ($900,000 p.a.), materials costs ($210,000 p.a.), marketing costs ($46,000 p.a.), and other costs ($25,000 p.a.). Over the 8 year life of the lab, these revenues and expenses are expected to change. The following summarises the base-case, worst-case and best-case scenarios concerning these changes:
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Base-case
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Worst-case
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Best-case
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Revenues
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Increase by 10% p.a.
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Increase by 6% p.a.
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Increase by 15% p.a.
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Costs (other than depreciation)
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Increase by 6% p.a.
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Increase by 10% p.a.
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Increase by 3% p.a.
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Base-case Worst-case Best-case
Revenues Increase by 10% p.a. Increase by 6% p.a. Increase by 15% p.a.
Costs (other than depreciation) Increase by 6% p.a. Increase by 10% p.a. Increase by 3% p.a.
The firm's tax rate is 30% and all analysis should be based on after-tax figures. The firm requires a 16% required rate of return on all potential investments.
Required:
- For the base-case, worst-case, and best-case scenarios calculate the following:
o After-tax cash flows.
o Payback periods.
o Discounted payback periods.
o Net present values.
o Profitability index.
- Other than modelling ‘best case' and ‘worst case' projections, discuss and describe what other capital budgeting approaches could be taken to allow for the increased riskiness of the estimated future cash flows.
- Discuss whether the above proposal should be accepted. Discuss any further information that you may require to help you make the accept/reject decision about this project.