Question

The GFA Company, originally established 16 years ago to make football, 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 test marketing, which was GH¢ 250,000. Also, the feasibility test carried out by analysts to assess the viability of the project costs 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 vacant building 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. Also, „Soft Flite‟ a substitute product, is expected to have a drop in its sales by 1000 units per annum. The selling price per unit of existing products is GH¢5 while the variable cost is GH¢ 4. This has no tax implications for the new product. 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 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

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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.

GFA will finance the total investment required for the production of the balls (including working capital investment) by issuing 100,000 new common stocks at GH¢ 2 per share from its existing shareholders. A total of GH¢ 200,000 is expected to be raised from the rights issue. It expects to finance the remaining from a bank loan from GDB at a rate of 12%. Mr. Dawadawa has estimated the beta of the project to be 2.5 and the average return for stocks traded on the Ghana Stock Exchange to be 10% while the rate on Government of Ghana traded Treasury bills is 5%. Required:

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

b. Discuss three (3) qualitative factors that the Management of GFA might have to consider

before making a decision.

c. What does the beta of the project represent and how will higher project betas affect your

decision?

d. Compare and contrast the beta of the project and explain how it will affect the return on

investment of the project.

Answer 1

Based on the given data, and associated tax assumptions, pls find below workings and further answers to the questions raised:

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

Based on the above workings, the NPV is significantly negative, and hence this investment in to this project is not feasible and not recommended.

b. Discuss three (3) qualitative factors that the Management of GFA might have to consider before making a decision.

Based on this data, the below factors need to be considered:

- Capital Structure and Source of Funding: The source of funding should be chosen very optimally as the cost of debt is much cheaper than that of cost of capital. It would have been more beneficial, if the entity would have gone for more debt rather than rights issue.

- Financial Projections: The financial projections are off the way from the inflationary trends (5%); This shall have impact on the feasibiliy study as well as the actual status of the investment, unless there is some very critical base for this way off % increase in selling price and cost trends.

- Initial Spent and Economies of Scale: The initial spent by the management towards feasibility study and marketing study costs are significantly higher than that of the deliverables from those study; As it is evident that the production quantity is very lower and the turnover doesn't support the operational requirement of the Project. Economies of scale shall have positive impact on the overall performance of the project. Mass production shall help in covering the fixed costs.

c. What does the beta of the project represent and how will higher project betas affect your decision?

BETA is the risk factor associated to a company; This is genrally evaluated using many factors including the company performance, risks associated, shareholding structure related risks, market risks, sectoral risks etc; The higher the BETA, the higher the cost of Equity and thus the higher the cost of capital (depending on the weightage)

d. Compare and contrast the beta of the project and explain how it will affect the return on investment of the project.

As mentioned above, the higher the BETA, the higher the cost of Equity and thus the higher the cost of capital (depending on the weightage); The higher the cost of capital, the lower the NPV of the project and viceversa.

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