Question

Question 10.

Healthstream Ltd is considering the possibility of manufacturing a new motorized treadmill model. The initial outlay for the manufacturing plan is $1.5 million. Staff at Healthstream have provided the following estimates for the project.

	Estimate
Items	Most likely	Pessimistic	Optimistic
Sales	1,500	1,000	2,000
Selling price	900	750	1,000
Fixed operating cost	90,000	100,000	80,000
Variable operating cost per unit of sale	50	65	40
Life of the plan	7	4	9

You have been asked to assess the project and if possible to determine what the major uncertainties are if the project is undertaken, knowing the company’s current capital structure is as follow:

Summary statement of the current financial position
	$	$
Assets
Inventory	120,000
Accounts Receivable	82,000
Land and Buildings	1,200,000
Plant and equipment	900,000
		2,302,000
Liabilities
Accounts Payable	100,000
Bank overdraft	200,000
8% bonds, $1000 face value	600,000	900,000
Shareholders' Equity
10% preference shares, $10 face value	200,000
Ordinary shares, $5 face value	1,000,000
Retained earnings	202,000	1,402,000
		2,302,000

Additional information includes:

The nominal interest rate on the bank overdraft is 12% pa, interest incurred monthly.

The bonds are currently selling at $970 each and mature in 5 years’ time

The preference shares are currently selling at $9.50 each

The ordinary shares are currently selling at $5.50 each

The company income tax rate is 30%

Last year, the company paid $120,000 and $28,000 dividends on ordinary shares and preference shares respectively. Also the management anticipates that dividends will grow at 5%pa.

Answer 1

Ans-

If the project is undertaken, company will have to raise the funds to manage the initial outlay of the project of $1.5 millions

This can be raised via bonds considering it being cheaper than the equity whose cost of capital in year 0 =12%

Hence the company will issue bonds to raise initial outlay of $1.5Millions

therefore total bond outstanding at the start if project-$2.1 Millions

Considering the most possible scenario:-

Total profit generated from the projects

Sales(1500 x 900) 1350000 Cost Variable cost(50 x 900) 45000 Fixed cost 90000 135000 dep 1500000 Net profit -285000 Interest on OD 24000 Interest on bonds 120000 PBT -1053000 PAT -737100

Considering the loss it is generating the company will not be able to generate enough profit for future years and hence it will not be able to give dividend in future years.

Also there is a possibility of company not able to generate enough cash in future years to survive in the business and might possibly be required to shut down the business.