CASE

The managing director of Tigwood Ltd believes that a market exists for microbooks. He has proposed that the company should market 100 best-selling books on microfiche, which can be read using a special microfiche reader that is connected to a television screen. A microfiche containing an entire book can be purchased from a photo-graphic company at 40 per cent of the average production cost of best-selling paperback books.

The average cost of producing paperback books is estimated at 1.50, and the average selling price of paper-backs is 3.95 each. Copyright fees of 20 per cent of the average selling price of the paperback books would be payable to the publishers of the paperbacks plus an initial lump sum that is still being negotiated but is expected to be 1.5 million. No tax allowances are available on this lump-sum payment. An agreement with the publisherswould be signed for a period of six years. Additional variable costs of staffing, handling and marketing are 20p per microfiche, and fixed costs are negligibleTigwood Ltd has spent 100,000 on market research and expects sales to be 1,500,000 units per year at an initial unit price of 2.The microfiche reader would be produced and marketed by another company.

Tigwood would finance the venture with a bank loan at an interest rate of 16 per cent per year. The companys money (nominal) cost of equity and real cost of equity are estimated to be 23 per cent p.a. and 12.6 per cent p.a., respectively. Tigwoods money weighted average cost of capital and real weighted average cost of capital are 18 per cent p.a. and 8 per cent p.a., respectively. The risk-free rate of interest is 11 per cent p.a. and the market return is 17 per cent p.a.

Corporation Tax is at the rate of 35 per cent, payable in the year the profit occurs. All cash flows may be assumed to be at the year end, unless otherwise stated.

Required

(a) Calculate the expected net present value of the microbooks project.

(b) Explain the reasons for your choice of discount rate in the answer to part (a). Discuss whether this rate is likely to be the most appropriate to use in the analysis of the proposed project.

(c) (i) Using sensitivity analysis, estimate by what percentage each of the following would have to change be-fore the project was no longer expected to be viable:

initial outlay;

annual contribution;

the life of the agreement;

the discount rate.

(ii) What are the limitations of this sensitivity analysis?

(d) What further information would be useful to help the company decide whether to undertake the microbook project?