Fox-Johnston plc is a UK-based manufacturer whose main product is the Govinator, a clever piece of equipment that saves time for its owner to do other things. It is an automated lawn maintenance server. It will cut the grass perfectly and dispense feed to the lawn at the same time and also has an aeration function. This takes a lot of effort out of gardening. The Govinator is made in the UK, but the specialised wheels, an essential component, are made outside the UK in Europe. The Finance Director has noticed that the cost of these wheels has been rising in price relentlessly over the last three or four years. He has now reached the stage where he is thinking it might be better to make the wheels in the UK and free the company of the costly European contract. He has asked you to put together a costing with an estimated NPV if the company switched to 100% UK manufacture. To do this, Fox-Johnston would have to buy a special piece of precision engineering equipment, which will come from Germany and will cost 700,000. There will be 100,000 of shipping and installation costs associated with the purchase, 60,000 of which would be capitalised, and the rest can be expensed straight away. The new equipment would be depreciated down to a salvage value of 100,000 and it is expected that at the end of the five-year project the equipment could be sold for that salvage value. It is estimated that the costs of manufacturing the wheels would be 600,000 in the first year and that this cost would rise in the future at a rate of 6% per annum. The cost of continuing to buy the wheels from Europe is estimated to be 900,000 in the first year and this cost would rise at a rate of 10% per annum into the future. There will be increased working capital requirements with the project. Initially 90,000 of extra working capital will be required and this would rise to 110,000 at the end of year 1 and rise again to 130,000 at the end of year 2, and from there it will remain constant until its return at the end of the project. Extra debt has been taken on for this project, which will result in annual interest payments of 35,000 through the five years. There will be a one-off cost of 250,000 in year 1 of specialist training of staff and extra quality supervision. The wheel assembly will take place in part of the facility that has been rented out to promising start-up businesses. The rentals had been running at 150,000 per year and that revenue stream will stop if Fox-Johnston decides on the all-UK solution. 1 The new equipment will have to be serviced by a specialist team from the German supplier as part of the ongoing warranty. This will take place at the end of the second and fourth years and will cost 80,000 each time. Fox-Johnston has an equity beta of 1.86, the risk-free rate of interest is 3.5% and the market risk premium is 6%. The company has a bond outstanding with five years to maturity, its price is 94.50; and it has a coupon of 8%, the yield to maturity for this bond is 9.45%. This is a normal line of business project for Fox-Johnston and the company is typically financed with 35% debt. The tax rate is 25%.

(a) Calculate the cost of capital for the project.

(b) This is a make-or-buy decision for Fox-Johnston. Lay out the cash flows and calculate the NPV. What course of action would you recommend for the company?

(c) Using an inappropriate discount rate is a common cause of mistakes in capital budgeting. If a company wanted to set up a new division in an area unrelated to its normal line of business, outline the steps that the company should take to establish a correct discount rate for the project.

(d) You can find equity betas for companies on financial websites such as ft.com. In October 2020, the drug company Astra Zeneca had an equity beta of 0.51 and the oil company Bowleven had an equity beta of 1.90. How would you interpret and explain these two figures? Also, explain how the equity beta differs from the asset beta. (6 marks) (e) Discuss why capital rationing might occur and clearly explain how a company with a limited budget would choose among a number of projects. Why might hard capital rationing occur and what could a company do to minimise this?