Green Star Acoustics Limited (GSA) is a medium-sized quoted manufacturing company

based in Scotland that makes highly specialised audio equipment. The Board of Directors is

considering a project where GSA will manufacture novelty wireless speakers (Contract

Speaker).

The information provided by the Board of Directors on this new project is as follows:

1.

Contract Speaker will involve GSA purchasing new equipment. This will cost 1

million, and there will be an extra 200,000 of capital installation costs. The new

equipment and the capital installation costs both attract capital allowances (tax

depreciation) on a straight line basis. The equipment will have no salvage value at

the end of its life.

2.

If the Contract Speaker project is undertaken, old equipment will be sold for 70,000.

3.

GSA will sell the speakers to the wholesalers for 22 each in Year 1 and this price

will be inflated by 2% each year, starting in Year 2. GSA expects to sell 70,000 units

in Year 1, rising to 75,000 in year 2, 80,000 in year 3, 90,000 in year 4 and 80,000 in

the final year.

4.

The speakers will have a variable cost of 15 each in Year 1 and this cost will

increase by 3% each year starting in Year 2.

5.

A specialist technician currently working for GSA will be seconded from her current

project (Contract Gartmore) to work on Contract Speaker for the first two years. Her

current salary is 65,000 per annum. GSA will require to hire two new people on a

temporary basis to perform her current work on Contract Gartmore for two years

whilst she is seconded to Contract Speaker. The salary bill for the two new

employees is expected to be 100,000 per annum. The specialist technician is

expected to return to her position on Contract Gartmore at the end of the second

year, which is when the temporary positions will end.

6.

There will be a strong marketing push in the first year, which will incur an extra

90,000 in costs. This marketing spend will drop to 60,000 a year for the rest of the

Contract Speaker project. GSA has allocated 200,000 of overheads per annum for

the Contract Speaker project, although only 30% of this is in respect of incremental

overheads.

7.

GSA expects to pay interest of 250,000 per year over the next five years. The

interest on the extra borrowing because of the Contract Speaker project will make up

40,000 of that figure per annum.

8.

At the start of the project it is expected that there will be 75,000 of working capital

required. This level will be maintained until the end of the project.

The company pays corporate taxation at a rate of 22% and this is payable in the year it is

incurred.

GSAs capital structure comprises 25 million in equity and 10 million of debt. GSAs equity

beta is 1.37 and its cost of debt is 4.5% before taxation. The risk-free rate of interest is 3.0%

and the average stock market return is 9%.

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