FINANCIAL MANAGEMENT

QUESTION 1

Mtawarira Ltd is looking to increase its production capacity in order to meet the forecasted demand for its product, rugby balls, which has seen an encouraging increase in demand and sales as a result of the success of various South African teams in international tournaments. Quotes have been received for the new machine, and management have established that the cost of the machine would be R 750 000 from its preferred supplier. Delivery costs are expected to be 10% of the purchase cost and import duties are expected to amount to R 55 000.

The new machine has an annual production capacity of 60 000 units and is expected to be used for a period of three years, after which it is expected to be sold at its estimated scrap value of R 185 000.

The existing machines have a production capacity of 75 000 units, so any excess demand will be met by the output of the new machine only.

Management have provided you with the following demand and production of rugby balls over the next three years:

YEAR UNITS

1 142 500

2 135 000

3 105 000

Management have estimated that, if the new product were to be sold to customers today, it would have a current selling price of R 50 per unit, and a variable cost of R 40 per unit. Price inflation is expected to be 5% per annum for sales and 3% per annum on variable costs. Fixed overheads are

anticipated to increase at 4% per annum each year from year two onwards. Fixed overheads are expected to amount to R 40 000 in the first year.

The manufacture and sale of the new product will give rise to an additional working capital requirement. Management have indicated that, based on the historic trends of the company, the working capital requirement at the start of each year will equate to approximately 2% of sales linked to the production from the new machine for that year.

Additional information:

Mtawarira Ltd currently pays corporation tax one year in arrears.

The current corporation tax rate is 28%.

Ignore VAT.

SARS currently permits a S12C capital allowance on new qualifying fixed asset additions over a fouryear period at 40%/20%/20%/20%.

A capital gains tax inclusion rate of 80% applies.

Mtawarira Ltd use their WACC (Weighted Average Cost of Capital) to appraise capital investment projects. The current WACC of the company has been calculated as 14%.

Required:

(Round off all calculations to the nearest rand except for price calculations to be rounded to two decimals)

a) Calculate the working capital requirement for Mtawarira Ltd for the new machine.

b) Calculate the initial investment for the new machine.

c) Calculate the operating cash flow for Mtawarira Ltd that relates to the new machines for year 13 only.

d) What type of capital expenditure (capex) will the acquisition of the new machine be classified as? Provide a reason for your answer.