EveryWear Ltd. (“EveryWear”) is a well-known South African clothing manufacturer and retailer with a nationwide footprint. While both EveryWear’s administration and manufacturing plant are located in Cape Town, Western Cape, the entity has retail outlets strategically located throughout the country. EveryWear is currently considering expanding their product lines to include shoes. New machinery, which is slightly different to the clothing manufacturing machinery, is required to mass manufacture shoes. To facilitate the manufacturing of this proposed new product line, two mutually exclusive machines are considered.

Option 1 – Machine P512 The first is machine P512 (“P512”). P512 has a purchase price of R864 300. The machine is considered an indivisible project. To assist with aiding the initial capital expense required, P512’s seller is, however, willing to extend instalment financing to EveryWear, which EveryWear will make use of. According to this agreement, EveryWear will pay an initial deposit of R250 000 when P512 is purchased. Thereafter, two equal annual instalments will be made to settle the debt at an interest rate of 11.8%. Due to this, the current weighted average cost of capital (“WACC”) of EveryWear will also rise to 12%. P512 has a useful life of 4 years and a residual value of zero Rand.

Option 2 - Machine X4LK The second option for machinery is machine X4LK (“X4LK”). X4LK is considered a divisible project as, although the complete machine could be bought for R910 000, EveryWear could and will utilise X4LK in conjunction with another machine, machine PP (“PP”), which they currently own but which is idle. This would enable EveryWear to initially only purchase a portion of X4LK for an amount of R470 000. PP was originally purchased for R520 000 and has a current tax value of R312 000 (no additional expenses were incurred for PP since its original acquisition). While X4LK has a useful life of 5 years (at which point the residual value will be R11 000, including inflation), PP’s remaining useful life is only 3 years (when it will have a residual value of R2 000). To facilitate the manufacturing process during the last portion of X4LK’s useful life, the second part of the X4LK machinery (which wasn’t initially purchased as EveryWear made use of machine PP) will be bought at a price of R405 000 (including inflation). Similar to part 1, part 2 of X4LK will have a useful life of 5 years, but the residual value is estimated to be R9 000, including inflation, at that point in time. The intention of EveryWear’s management is to continue utilising the second portion of X4LK, whether it be reinvesting in this investment option or an adjusted investment (which ever, a final decision will be made after re-evaluating the project’s success towards the end of the initial project) up until the end of its useful life.

The new shoe product line will require additional manufacturing space. EveryWear had therefore consulted an engineer, at a cost of R39 000, to assist with the estimation of the additional factory space required. Currently EveryWear is renting the manufacturing factory for R240 000 per annum. Considering the estimation received from the engineer, the factory rent will increase to R264 000 per annum. Regardless of whether P512 or X4LK is employed, the investment in working capital (of which the investment will be made at the beginning of a period and the recovery only at the end of a period) for the shoe product line will be R30 000 (excluding inflation) per annum. The revenue generated is also estimated to be the same, irrespective of which machinery is chosen. The expected revenues per annum of the shoe product line are as follows:

Possible outcome Quantity sold Price per unit (pair of shoes) (R) Possibility Highly successful 55 000 R290 25% Successful 36 000 R290 44% Failure 19 000 R290 31% Since each machine incurs different expenses, the operating profit margin generated will vary depending on which machine is chosen. Should the P512 be opted for, the net operating profit margin would be 44%, while it would be 38% using the X4LK.

These net operating profits exclude the other mentioned expenses (including depreciation). Additional Information: · All mentioned machinery qualifies for a section 12C wear-and-tear deduction in terms of the Income Tax Act and are considered new machinery, except for PP, which was purchased second-hand. · EveryWear’s depreciation policy for the entity’s machinery is 4 years on the straight-line basis. · The South African Income Tax rate is 28% for companies. The upcoming change in the Income Tax rate to 27% should be ignored for the entire question. · Any wear-and-tear allowances on the buildings may be ignored. · Section 11(o) of the Income Tax Act is elected where applicable. · Any Capital Gains Tax consequences may be ignored. · VAT may be ignored. · EveryWear’s current weighted average cost of capital (“WACC”) is 11.2%. · Inflation is expected to rise from the current rate of 4.5% to 5% after three years’ time from today. All above amounts (except when stated otherwise) are at current prices. · Nominal cash flows are to be used in the evaluations.

Required: Advise EveryWear Ltd. whether Machine P512 or Machine X4LK should be obtained. Separately for Machine P512 and Machine X4LK, make use of the following methods and calculations to substantiate your answer. Show ALL workings clearly. · Net Present Value of net cash flows, · Internal Rate of Return and · Equivalent Annual Annuities methods