Windy Sails Pty. Ltd, trading as Windy Sails, is a family business that produces sailing boats, including Optimist Dinghies (oppies), for the Australian market. Established 45 years ago as a micro business making just a few small dinghies a year, Windy Sails has grown into a successful business that is well respected by the sailing fraternity. SAMA is present day customer of Windy Sails.

Whilst forty-five years ago, small dinghies were crafted from wood, nowadays Windy Sails uses fibreglass as the major component in its boat building. Moreover, the only dinghies that Windy Sails manufactures now are ones that can be registered in the Optimist class (oppies). Windy Sails does make some other sailing boats, other than oppies.

Windy Sails produces 200 oppies per month and is able to sell all the oppies it produces. Indeed, it could possibly sell more oppies than it produces, but the family that owns Windy Sails prefers to keep its output at this level.In making an oppie, the most important part of the production is the cutting and shaping of the fibreglass. This work, which involves using a sophisticated machine, is done by a skilled tradesperson who is paid on an hourly basis. The cost of labour for 2020 is $46 per hour, with this amount including all associated costs.

It is expected that this cost will rise by 1.5%. per annum for at least the next five years. The machine that is needed to produce the oppies is a fibreglass cutter / shaper. For the past twenty years Windy Sales have used machines manufactured and supported by Precision Craft. Windy Sales needs only one of this cutter / shaper machines at any one time. With the Precision Craft machine, the expected life has been five years, and so every five years, the previous machine has been replaced by a new version. At the beginning of January 2021, Windy Sales wants to replace the present Precision Craft machine. It will pay cash for the new machine.

On investigating the situation, the managing director of Windy Sails has found that the latest Precision Craft machine has the following qualities:

Expected life:5 years

Cost of machine as at 1 January 2021:$500,000

Installation cost for machine (a capital expense):$5000

Initial training for operator: $600

Yearly maintenance contract for 2021: $2400

machine time needed per oppie:40 minutes

Current Cost of fibreglass and related materials per oppie $300

 

However, the managing director of Windy Sails, who keeps in touch with industry trends, has recently visited a trade show where he saw an alternative machine, the Diamond Elite. This

 

11machine offers advantages over the Precision Craft machine, in particular being able to carry out the necessary tasks in a shorter time per oppie. Another advantage is that the Diamond Elite makes it possible to be more economical with the fiberglass. Whilst the price of the Diamond Elite machine is the same as the Precision Craft machine, its useful life is only 4 years. The managing director arranged for an independent assessment of the company manufacturing the Diamond Elite machine, paying $1000 for the report. After receiving this report, Windy Sails is prepared to purchase either of the Precision Craft or the Diamond Elite machines.

The details for the Diamond Elite machine are as follows:

Expected life:4 years

Cost of machine as at 1 January 2021:$500,000

Installation cost for machine ( a capital expense):$20000

Initial training for operator: $3000

Yearly maintenance contract for 2021: $3600

machine time needed per oppie:30 minutes

Current Cost of fibreglass and related materials per oppie $275

No matter what machine is chosen, the following apply:It can be expected that all costs except the cost of labour will rise by 2% per annum.

The effective corporate tax rate is 22.5%The existing machine will be sold for $500. Its book value is $0.

Based on past experience, it can be expected that, for whichever machine is chosen, at the end of its useful life, it can be sold for scrap for $500.All other costs of producing the oppies will be the same, no matter which of the machines is purchased.As at 1 October 2020, Windy Sails Pty Ltd has debt to the value of $12 million. Its equity is of value $20 million The debt consists of a mortgage of $11million at 4.2% p.a compounding monthly, an interest only loan of $800,000 at an effective rate of 5% per annum, and an overdraft of $200,000 at a rate of 12% per annum compounding daily.From previous consulting work for the manufacturing sector, and considering the present capital structure, a financial advisor has estimated Windy Sails Pty Ltd.’s beta as 1.25. Short term treasury securities are currently selling at a yield of 1.5% per annum. The market return is presently 11.5%.

It is now October 2020

 

1. With the given information regarding the sources of funds, estimate the Weighted Average Cost of Capital (WACC) for Windy Sails Pty. Ltd

2. Using the WACC you have established for Windy Sails Pty. Ltd., undertake an NPV analysis of the two alternatives Windy Sails Pty Ltd has with regards to its new cutting/shaping machine