Luncaster Sweets plc is considering introducing a new range of cakes, the Lemon-Lime cheesecake, to complement their existing product line. To decide whether to proceed with this project, the company has commissioned a report from a consultant. The consultant has identified the following likely outcomes if they choose to go ahead.

Sales of cheesecakes are likely to be 400,000 units in the first year and will increase by 5 percent per year each year until a new range will be needed to replace them at the end of 4 years. As a result of selling the new cake, the company expects to increase the sales of their existing tea range (The Tea) from 220,000 boxes per year to 300,000 boxes per year for the 4 years of the project.

After market research which cost the firm 55,000, a selling price of 6 per cake has been agreed. The cost of ingredients to make the cake is likely to be 2.50 per cake with other variable costs of production likely to come to 0.50 per cake. The Tea currently has a selling price of 1.50 and variable costs of production of 0.50.

An issue of concern is that selling the cheesecakes will reduce sales of the companys existing traditional cheesecakes New Yorksher. The consultant estimates that sale of New Yorksher could go down from 800,000 per year to 500,000 per year. The New Yorksher sells for 4 and has a variable cost of production of 2.

To produce the new cake, a machine costing 980,000 will be acquired. This value will be depreciated on a straight line basis to zero salvage value over the 4 years of the project, but it will be sold for 25,000 at that time. To market the cakes the company intends to use an unused office which they bought 10 years ago for 100,000 and which has a current market value of 150,000. The market value of the office is not expected to change over the term of the project. The company will invest 30,000 in working capital to cover the need for credit sales at the start of the project which will be refunded at the end of the project. The company currently has fixed costs of 200,000 and these are expected to increase to 300,000 per year if the new cake is produced. Taxes are 30 percent.

REQUIRED:

1. Luncaster Sweets plc has 15 million shares of equity outstanding with a price of 10 per share and a historic annual return of 15%. It also has 52.95 million of long term debt with a market interest rate of 5%. Calculate Luncaster Sweets plcs weighted average cost of capital. [ 5 marks ]

2. Using all relevant cashflows and the rate calculated in (i) compute the NPV of the project and advise the firm as to whether it should go ahead with the project. [20 marks] 3. Air conditioning for the Oxcliffe college residences will cost 1.5 million to install and 200,000 per year to operate. The system should last 25 years. The cost of capital is 5%, and the college pays no taxes. What is the equivalent annual cost? [5 marks]

4. Discuss reasons why does traditional NPV analysis tend to underestimate the true value of a capital budgeting project and suggest how managerial options can improve the accuracy of the traditional NPV analysis. [ 20 marks ]