Capital Budgeting Question

You are an analyst working in the finance department of Fedal Ltd. Fedal is a public listed tennis racquet company that is based in Melbourne. The company is co-founded by two former world number one tennis players. Fedal has recently come up with its latest innovation in tennis racquet which uses a better material than the currently used graphite material. The new material significantly reduce vibrations in tennis racquets. In order to manufacture the new tennis racquets, Fedal needs to purchase new machinery and must decide whether to purchase large or small machinery. New machinery has an expected life of 8 years, after which salvage values are $150,000 for the large machinery and $80,000 for the small machinery. Market research has estimated that there is a 65% probability that demand will be high throughout the next 8 years, and a 35% probability that demand will be low throughout the next 8 years.

The large machinery is expected to cost $1,500,000, with an extra installation and shipping costs of $50,000. The small machinery is expected to cost $700,000, with additional installation and shipping costs of $45,000. The company accountings policy is to depreciate using the straight line approach, evenly split across the useful life. There is also an initial increase in net working capital of $200,000 for the large machinery, and $130,000 for the small machinery. The initial outlays associated with the net working capital is recoverable at the end of their useful life.

In the event of high demand, the company expects a yearly operating revenue of $6,500,000 if it acquires the large machinery, and a yearly operating revenue of $2,250,000 for the small machinery. If the demand is low, yearly operating revenue is forecasted to be $2,000,000 for both the large and small machinery. Annual variable costs associated with operating the machinery are expected to be 75% of the operating revenue for the large machinery and 65% of the operating revenue for the small machinery. In addition, given that player-endorsed tennis brand increases sales, your company has decided to endorse uprising top 300 doubles tennis players with significant marketability, Special Js, at a cost of $800,000 per year if the company chooses to proceed with the large machinery. If the small machinery is chosen, the company only has the budget to endorse one of the players at a cost of $450,000 per year.

You have recently evaluated the capital structure of the company and believe that it is operating at the optimal level of 50% equity and 50% debt. The weighted average cost of capital (WACC) from this capital structure is 12.5%. Assume that tax rate is 30%. You would also like to understand how sensitive your capital budgeting decisions are due to changes in WACC. As such, in addition to determining which machinery to invest, you want to investigate the effects of WACC on NPV and the cross-over rate of the large and small machinery for the overall outcome.

Required

You are to prepare a report, to present to the CEO, showing (1) the various cash flows based on the different scenarios and (2) the sensitivity analysis using different WACC and the calculation of cross-over rates. Using Excel as your main analysis tool, evaluate whether the company should proceed with the purchase of large or small machinery to manufacture tennis racquets, taking into consideration of the various scenarios. Based on your analysis, you should also provide recommendations on how the company may be able to further maximize shareholders wealth by altering the capital structure. Show all workings in the appendix of the report. You should also clearly state any assumptions (if any) made in your analysis.

(This was all that was provided for the question)