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 EXAMINER: ISAAC OFOEDA Page 3 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, pls find below workings:

As mentioned in the given data, tax assumptions for capital profits as well as contribution loss from "Soft Flite" balls;

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

Answer: The NPV is significantly negative and thus this investment 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 the given data, couple of factors to be considered:

One: The capital structure is very important to evaluate the cost of capital on the overall funding requirement. In this scenario, the cost of debt is very cheap as compared to the cost of equity; Hence, the weightage of sourcing between debt and equity to be carefully considered to optimally count for lowest possible cost of capital;

Two: The financial estimates make key base for any evaluations; Here, is seems the trends of selling price and cost price of the new product is not at all in line with the inflationary trend; This deviation from the inflation is required to have a careful study as there shall be significant chance of failure of the evaluation.

Three: The initial spent made by the Management towards marketing costs and feasibility study are significantly higher as compared to deliverables of this project. The annual turnover expected for Year 1 and further gross margin on the same are so lower as compared to the initial costs as spent on the marketing and feasibility study. Mass production shall always have its benefits of economies of scale. Here, the quantity of production and sales are significantly lower to achieve the breakeven situation.

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

Beta factor is the risk factor associated with the company. This is evaluated based on many factors, including the operational efficiency of the company, shareholding structure, Balance Sheet strength, market based, sectoral risks in which the company is in to, etc; The Beta factor impacts in a directly proportional manner to the cost of equity. The higher the beta factor , the higher the cost of equity and thus the higher cost of capital (WACC - 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 factor , the higher the cost of capital and lower the NPV; and viceversa.

Year 0 Terminal Year 1 5,000 20.00 10.00 1,000 5.00 4.00 -1,000.00 Year 2 8,000 20.40 11.00 1,000 5.00 4.00 -1,000.00 Year 3 12,000 20.81 12.10 1,000 5.00 4.00 -1,000.00 Year 4 10,000 21.22 13.31 1,000 5.00 4.00 -1,000.00 Year 5 6,000 21.65 14.64 1,000 5.00 4.00 -1,000.00 Project (GH) No.of Units - "High Flite" Price per unit Production Costs No.of Units - "Soft Flite" Price per unit Production Costs Opportunity Loss (No Tax implications as per) Cost of Bowling Machine Cost of Test Marketing Feasibility Test cost Opportunity Loss - Sale of Land /Building Salvage Value Additional Working Capital Change in Working Capital Depreciation -1,00,000 -2,50,000 -1,00,000 -1,50,000 30,000 -10,000 -10,000 -10,000 -16,320 -6,320 20,000 -24,970 -8,650 20,000 -21,224 3,745 20,000 -12,989 8,235 20,000 12,989 20,000 1,00,000 1,63,200 2,49,696 2,12,242 1,29,892 Revenue Other Income 30,000 Variable Cost Depreciation EBT Tax@ 34% Net Income 50,000 20,000 30,000 10,200 19,800 88,000 20,000 55,200 18,768 36,432 1,45,200 20,000 84,496 28,729 55,767 1,33,100 20,000 59,142 20,108 39,033 87,846 20,000 22,046 7,496 14,550 30,000 30,000 -6,10,000 38,800 49,112 66,118 61,779 41,785 42,989 Cash Flows (Net Income + Depreciation + Change in WC) Discounting Factor Discounted Cash Flow Cumulative Discounted Cash Flow 1 -6,10,000 -6,10,000 0.8588 33,321 -5,76,679 0.7375 36,220 -5,40,459 0.6333 41,876 -4,98,584 0.5439 33,602 -4,64,982 0.4671 19,518 -4,45,464 0.4011 17,244 -4,28,220 NPV -4,28,220 -17.3% IRR Discounting Factor 16.44% 10% 2% Cost of Equity: Average Return Risk free Return Risk Premium Beta Cost of Equity: Cost of Debt 8% 2.5 22.00% 12% Initial Investment: Cost of Equipment Cost of Test Marketing Feasibility Test cost Total Investment 1,00,000 2,50,000 1,00,000 4,50,000 - Thru Equity - Thru Debt 2,00,000 2,50,000 Weight% 44.44% 55.56% Return 22.00% 12% WACC % 9.78% 6.67% 16.44%