Question

Question 1

Aguilera Acoustics, Inc. (AAI), projects unit sales for a new seven-octave voice emulation implant as follows:

Year	Unit Sales
1	8300
2	9200
3	10400
4	9800
5	8400

Production of the implants will require GH¢ 150,000 in net working capital to start and additional net working capital investments each year equal to 15 percent of the projected sales for that year. In the final year of the project, net working capital will decline to zero as the project is wound down. In other words, the investment in working capital is to be completely recovered by the end of the project’s life. Total fixed costs are GH¢ 240,000 per year, variable production costs are GH¢ 190 per unit, and the units are priced at GH¢ 345 each. The equipment needed to begin production has an installed cost of GH¢ 2,300,000. Because the implants are intended for professional singers, this equipment depreciated using the straight-line basis. In five years, this equipment can be sold for about 20 percent of its acquisition cost. The cost of acquisition and installation is to be financed partly by a loan from Swez Bank to the tune of GH¢ 1,000,000 at an interest rate of 15% and the remaining financed from the internal resource of the firm. The cost of equity is 20%. AAI is in the 25 percent marginal tax bracket. Based on these preliminary project estimates,

Required

Advise whether the company should buy the equipment or not using the NPV              

Question 2

The GFA Company, originally established 16 years ago to make footballs, is now a leading producer of tennis balls, baseballs, footballs, and golf balls. Nine years ago, the company introduced “High Flite,” its first line of high-performance golf balls. GFA management has sought opportunities in whatever businesses seem to have some potential for cash flow. Recently Mr Dawadawa, vice president of the GFA Company, identified another segment of the sports ball market that looked promising and that he felt was not adequately served by larger manufacturers.

As a result, the GFA Company investigated the marketing potential of brightly coloured bowling balls. GFA sent a questionnaire to consumers in three markets: Accra, Kumasi, and Koforidua. The results of the three questionnaires were much better than expected and supported the conclusion that the brightly coloured bowling balls could achieve a 10 to 15 percent share of the market. Of course, some people at GFA complained about the cost of the test marketing, which was GH¢ 250,000. In addition, feasibility test carried out by analyst to assess the viability of the project cost GH¢ 100,000

In any case, the GFA Company is now considering investing in a machine to produce bowling balls. The bowling balls would be manufactured in a building owned by the firm and located near Madina. This building, which is vacant, and the land can be sold for GH¢ 150,000 after taxes.

Working with his staff, Dawadawa is preparing an analysis of the proposed new product. He summarizes his assumptions as follows: The cost of the bowling ball machine is GH¢100,000 and it is expected to last five years. At the end of five years, the machine will be sold at a price estimated to be GH¢ 30,000. The machine is depreciated on straight line basis. The company is exempt from capital gains tax. Production by year during the five-year life of the machine is expected to be as follows: 5,000 units, 8,000 units, 12,000 units, 10,000 units, and 6,000 units. The price of bowling balls in the first year will be GH¢20. The bowling ball market is highly competitive, so Dawadawa believes that the price of bowling balls will increase at only 2 percent per year, as compared to the anticipated general inflation rate of 5 percent.

Conversely, the plastic used to produce bowling balls is rapidly becoming more expensive. Because of this, production cash outflows are expected to grow at 10 percent per year. First-year production costs will be GH¢10 per unit. Dawadawa has determined, based on GFA’s taxable income, that the appropriate incremental corporate tax rate in the bowling ball project is 34 percent.

Like any other manufacturing firm, GFA finds that it must maintain an investment in working capital. Management determines that an initial investment (at Year 0) in net working capital of GH¢10,000 is required. Subsequently, net working capital at the end of each year will be equal to 10 percent of sales for that year. In the final year of the project, net working capital will decline to zero as the project is wound down. In other words, the investment in working capital is to be completely recovered by the end of the project’s life. Again, the company paid GH¢20,000 per year in interest on loans contracted from Kelewele Bank Ghana Limited.

The required rate of return of the project is 15%.

Required:

Evaluate the project using NPV and advise the Management of GFA whether or not it should introduce the bowling balls        

Question 3

Kako Ltd is considering introducing a new product unto the market. This will require the injection of capital to the tune of GH¢20,000 for the purchase of the equipment for production. The cost of the building that Kako Ltd intends to use for the project is GH¢30,000. The Production and Marketing department has presented the information in the table below:

	2019
Variable cost per unit of the product	GH¢2
Selling price per unit	GH¢6
Quantity	4000 units per annum

Again the following information should be taken not of:

• Feasibility studies cost the company GH¢2000
• Test marketing expenses amounts to GH¢3000
• Variable cost will increase by 5% per annum
• Selling price will increase by 10% per annum
• Marketing expense will be 5% of sales revenue per year
• An initial working capital investment of GH¢2000 will be made. Subsequently, net working capital at the end of each year will be equal to 10 percent of sales for that year. In the final year of the project, net working capital will decline to zero as the project is wound down. In other words, the investment in working capital is to be completely recovered by the end of the project’s life
• As a result of the introduction of the new product, sales of existing products will drop by 1000 units per annum. The selling price per unit of existing products is GH¢5 while the variable cost is GH¢ 4.
• Overhead cost will be fixed at GH¢6000 per year
• The project will last for five years (2019-2023) and the machines will be sold for a scrap value of GH¢2000
• Charge depreciation using the straight line method
• CPC falls within the 25% tax bracket
• The project cost of capital is 15%

Required:

Evaluate the project using NPV and advise the Management of Kako Ltd whether or not it should introduce the new product.

              

Question 4

With the growing popularity of casual surf print clothing, two recent MBA graduates decided to broaden this casual surf concept to encompass a “surf lifestyle for the home.” With limited capital, they decided to focus on surf print table and floor lamps to accent people’s homes. They projected unit sales of these lamps to be 7,000 in the first year, with growth of 8 percent each year for the next five years. Production of these lamps will require GH¢35,000 in net working capital to start. Total fixed costs are GH¢ 95,000 per year, variable production costs are GH¢ 20 per unit, and the units are priced at GH¢48 each. The equipment needed to begin production will cost GH¢175,000. The equipment will be depreciated using the straight-line method over a five-year life and is not expected to have a salvage value. The effective tax rate is 34 percent, and the required rate of return is 25 percent. Evaluate the project using NPV.

Question 5

Howell Petroleum is considering a new project that complements its existing business. The machine required for the project costs GH¢3.8 million. The marketing department predicts that sales related to the project will be GH¢2.5 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straightline method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. Howell also needs to add net working capital of GH¢ 150,000 immediately. The additional net working capital will be recovered in full at the end of the project’s life. The corporate tax rate is 35 percent. The required rate of return for Howell is 16 percent. Should Howell proceed with the project?

                                                            

Answer 1

Question 1]

WACC = (weight of debt * cost of debt) + (weight of common stock * cost of common stock)

cost of debt = interest rate * (1 - tax rate)

weight of debt = loan / installed cost of equipment = 1,000,000 / 2,300,000

weight of equity = cost of equipment financed by internal resource = 1,300,000 / 2,300,000

WACC = ((1,000,000 / 2,300,000) * 15% * (1 - 25%)) + ((1,300,000 / 2,300,000) * 20%)

WACC = 16.1957%

Operating cash flow (OCF) each year = income after tax + depreciation - change in working capital

profit on sale of equipment at end of year 5 = sale price - book value

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value - tax on profit on sale of equipment   

NPV is calculated using NPV function in Excel

NPV is 1,022,912

Yes, the equipment should be bought as the NPV is positive