Agello plc$$s chief executive is concerned that the cost of the components being used

in its manufacturing process keeps rising and it doesn$$t seem to have any control

over the rate of price increase. The CEO thinks that the supplier is taking his custom

for granted and can keep pushing the price up$,$ because there are very few

alternatives for Agello.

The CEO is considering the option of Agello making the components itself and

cutting out the supplier. The CEO has asked you to prepare a report on the

attractiveness of this option. The report should show whether it is financially

beneficial to switch to making the components and make a recommendation.

A new machine would need to be bought to make the components and an area of

the complex that Agello owns would have to be given over to this venture. The

machine would cost $850,000$ and would have associated installation costs of

$90,000,$ which would be capitalised, and $50,000,$ which would be expensed. The

operation would take place on floor space that has been rented out at a rate of

$200,000$ per annum. The machine would be depreciated straight line down to a

value of $150,000$ over five years. It is expected that the machine could be sold for

that amount at the end of the project$$s five$-$year life. Extra working capital of

$150,000$ would be needed to get the operation going. Working capital would be

maintained at that level until the end of the project.

The cost of manufacturing the components would be $700,000$ in the first year and it

is assumed that the cost of manufacture would increase at a rate of $4\%$ per annum

thereafter through to the end of the project. The cost of buying in the components for

the next year would be $1,100,000$ and this cost has been rising at a rate of $10\%$ per

annum. It is assumed that this rate of increase would continue for the life of the

project.

If Agello goes ahead with manufacturing the components itself, the new machine

would need an overhaul at the end of the third year. This is expected to cost

$125,000.$ During the first year of operation two specialists from the rest of the

company would come and work on this project. As a result of this, it is expected that

expenses incurred by the rest of the company would be increased by $300,000.$

Agello is a relatively large company and this is a regular project in its normal line of

business. Agello has $35\%$ debt in its capital structure and the debt carries a beta of

$0\mathrm{.}30.$ The ungeared beta is $0\mathrm{.}95.$ The company faces a tax rate of $30\%,$ the risk$-$free

rate of interest is $4\mathrm{.}5\%$ and the equity risk premium is $6\mathrm{.}5\%.$ Agello has been paying

dividends that are growing at a rate of $5\%$ per annum.

Required:

$($a$)$ Calculate the cost of capital required for this project. $(4$ marks$)$

$($b$)$ For your report, lay out the relevant cash flows, do a net present value

calculation and make a recommendation to the CEO. $(10$ marks$)$

$($c$)$ You make a mistake in estimating the NPV of a project. You have discounted

the net income rather than the cash flows to the project. Would you expect the

NPV that you have calculated to be higher or lower than the NPV using cash

flows? Explain why there is a difference. $(5$ marks$)$

$($d$)$ When a firm is faced with a capital rationing situation, how can the profitability

index be used to select the most attractive projects for the firm? Explain why

choosing projects with the highest profitability index might not always lead to

the best decision. $(6$ marks$)$

$($e$)$ The standard deviation on a portfolio is typically less than the weighted

average of the standard deviations of the shares in the portfolio. Why is this?

Explain why a portfolio$$s beta is the weighted average of the betas of the

shares in the portfolio. $(5$ marks$)$