Following the recent "Raygun" debacle, market interest in breakdancing and related sportswear

is reaching unprecedented levels. NewGen Sports is keen to capitalise on this phenomenon and

are planning to launch a range of specialised high$-$tech footwear and accessories as part of their

'Break Project'. With the recent cost of living crisis and global economic slowdown, the CEO of

NewGen Sports is skeptical. As a financial analyst for the CFO of NewGen Sports, you have been

asked to analyse the business case and help the CEO make a decision.

The Break project is expected to run for six years, with a proposed average retail price of $$190.$

Management expects to achieve a gross margin of $40\%$ on retail sales. Early projections show

expected sales of $1\mathrm{.}2$ million pairs in the first year of the project, followed by $1\mathrm{.}6$ and $1\mathrm{.}4$ million

pairs. In the following year's Olympic Games, it is expected that one of the athletes supported by

the Break project will win a medal, leading to forecasts of $2\mathrm{.}4$ million pairs sold, followed by $1\mathrm{.}8$

and $0\mathrm{.}9$ million pairs sold, as the initial excitement dies down and new projects are launched. In

addition, in the first two years after the launch of the Break project, NewGen is expected to have

their existing sales from other brands reduce by $$35$ million and $$15$ million respectively, with the

same gross margin as the Break project products.

In order to manufacture the Break Project products, NewGen Sports will need to build a new

factory in Thailand. The factory will require an immediate investment of $$150$ million, which will

be depreciated on a straight$-$line basis to zero over $39$ years. Based on current market data, the

factory is expected to be sold for $$102$ million at the end of the project. In addition, NewGen

Sports will be required to immediately purchase $$15$ million in equipment. Freight and

installation of the equipment will cost $$6$ million. The cost of the equipment and

freight$/$installation will be depreciated on a straight$-$line basis to zero over six years, with the

expectation that the equipment can be sold at the end of the project for $$3$ million.

In order to get the factory up and running, two of the company's working capital accounts are

expected to increase immediately. Approximately $$15$ million of inventory will be required to fill

the supply chain. All working capital is expected to be recovered by the end of the project.

Variable costs are expected to be $55\%$ of revenues, while selling, general and administrative

expenses are expected to be $$7$ million per annum. NewGen has already spent $$2$ million on

research and development on the Break project products. NewGen has an effective tax rate of

$40\%.$ They also expect advertising and promotion costs for the project to be $$25$ million in the first

year, with growth of $2\mathrm{.}5\%$ in the next two years, followed by a decline of $1\mathrm{.}5\%$ in the remaining

years.

NewGen currently has $1$ million bonds $($each with a face value of $$1,000)$ outstanding in the

market, paying a coupon of $4\mathrm{.}85\%$ p$.$a$.$ paid annually, with a maturity of $8$ years. These bonds are

trading at $$975\mathrm{.}25$ in the market. NewGen also has $11$ million ordinary shares trading in the

market. NewGen has a beta of $1\mathrm{.}15$ and the ASX $300$ index return is $8\mathrm{.}2\%.$ The long$-$term

government bond yield is $3\mathrm{.}15\%.$ They just paid a dividend of $$3\mathrm{.}2,$ and it is expected to grow by

$3\mathrm{.}1\%.$ NewGen$$s shares are trading in the market at a $5\%$ discount to your calculated intrinsic value. The Break project is similar to NewGen's existing operations and is going to be financed

with a similar mix of NewGen's capital structure.

$5.$ Why do you think valuing NewGen's bonds is a simpler process than valuing equities?