Estimate the discount rate for the project. Justify your calculations & approach

Superstar Manufacturing Products (SSMP) Corporation is a public listed company. It is considering a proposal to purchase a new machine to manufacture a new product. The new machine will cost $1 million. The machine has an estimated life of three years for accounting and taxation purposes. Estimated salvage value at the end of three years is $100,000 in today's dollars. The tax rate is 30% and the tax is payable in the year in which profit is earned. An investment allowance of twenty percent is available (Note: A business investment allowance is a common tool used by governments for economic stimulus. It is an additional tax deduction available for the purchase of plant, equipment and vehicles and encourages business people to invest in income-producing business assets. In this case, there would be an additional and immediate write-off of $200,000 plus normal depreciation over time). The purchase can be fully financed by debt, which is available at the firm's normal borrowing rate of 6 percent. One hundred percent financing is available with principal and interest payments at the end of each year for three years of $374,110. The firm does not intend to change its target debt/equity ratio. Addition net working capital of $60,000 is required immediately to support the project. Assume that this amount will be recovered at the end of three years and there will be no other networking capital changes during the project. The new product will absorb $50,000 of allocated head office administration costs each year. This is in accordance with the firm's policy of allocating all corporate overhead costs to divisions. Extra marketing and administration expenditure due to this project will be $40,000 for Year 1 and will increase by the inflation rate of 3% per annum. An amount of $30,000 has been spent on a pilot study and market research for the new product. The figures provided above are based on this work. Projected sales for the new product are 30,000 units at $110 per unit for Year one. Units sold will rise at the rate of 3,000 per year over the next two years. Cash expenses are estimated to be 80 percent of sales. Prices determining revenue and expenditure will increase at the inflation rate of 3% pa. The finance manager believes that SSMP's recent activities, mainly involving various kinds of manufacturing products are reasonably representative of this proposed project's risk. Except for initial outlays, assume cash flows occur at the end of each year (unless otherwise stated). For simplicity, assume the company is subject to the classical tax system rather than the imputation tax system. Financial Background A recent graduate has stated that the 13% per annum discount rate that SSMP has used to evaluate projects is "arbitrary" and believes that a more rational approach should be used. The graduate has gathered the following data: * Totally comprises debentures with an average of 3 years to maturity and coupons of 6% per annum paid half yearly. Current Market Data - SSMP Ltd's shares are trading on the stock exchange at a current price of $3 each and have a beta ( ) of 1.6. - The risk-free rate is 4.5% per annum. - The company's debentures have a current yield of 7% per annum (Note: current yield is defined as annual coupon /market price). - The market risk premium is estimated at 7.0% per annum. Superstar Manufacturing Products (SSMP) Corporation is a public listed company. It is considering a proposal to purchase a new machine to manufacture a new product. The new machine will cost $1 million. The machine has an estimated life of three years for accounting and taxation purposes. Estimated salvage value at the end of three years is $100,000 in today's dollars. The tax rate is 30% and the tax is payable in the year in which profit is earned. An investment allowance of twenty percent is available (Note: A business investment allowance is a common tool used by governments for economic stimulus. It is an additional tax deduction available for the purchase of plant, equipment and vehicles and encourages business people to invest in income-producing business assets. In this case, there would be an additional and immediate write-off of $200,000 plus normal depreciation over time). The purchase can be fully financed by debt, which is available at the firm's normal borrowing rate of 6 percent. One hundred percent financing is available with principal and interest payments at the end of each year for three years of $374,110. The firm does not intend to change its target debt/equity ratio. Addition net working capital of $60,000 is required immediately to support the project. Assume that this amount will be recovered at the end of three years and there will be no other networking capital changes during the project. The new product will absorb $50,000 of allocated head office administration costs each year. This is in accordance with the firm's policy of allocating all corporate overhead costs to divisions. Extra marketing and administration expenditure due to this project will be $40,000 for Year 1 and will increase by the inflation rate of 3% per annum. An amount of $30,000 has been spent on a pilot study and market research for the new product. The figures provided above are based on this work. Projected sales for the new product are 30,000 units at $110 per unit for Year one. Units sold will rise at the rate of 3,000 per year over the next two years. Cash expenses are estimated to be 80 percent of sales. Prices determining revenue and expenditure will increase at the inflation rate of 3% pa. The finance manager believes that SSMP's recent activities, mainly involving various kinds of manufacturing products are reasonably representative of this proposed project's risk. Except for initial outlays, assume cash flows occur at the end of each year (unless otherwise stated). For simplicity, assume the company is subject to the classical tax system rather than the imputation tax system. Financial Background A recent graduate has stated that the 13% per annum discount rate that SSMP has used to evaluate projects is "arbitrary" and believes that a more rational approach should be used. The graduate has gathered the following data: * Totally comprises debentures with an average of 3 years to maturity and coupons of 6% per annum paid half yearly. Current Market Data - SSMP Ltd's shares are trading on the stock exchange at a current price of $3 each and have a beta ( ) of 1.6. - The risk-free rate is 4.5% per annum. - The company's debentures have a current yield of 7% per annum (Note: current yield is defined as annual coupon /market price). - The market risk premium is estimated at 7.0% per annum