Otto Klopp is CEO of Salah Precision Instruments (SPI), a manufacturing company that makes Bluetooth portable speakers. It is considering a project where it will make waterproof bluetooth speakers; this is considered to be in the normal area of its business.

This will involve the company buying new equipment. This will cost 1,200,000, and there will also be an extra 80,000 of capitalised installation costs and 40,000 of expensed installation costs. This new equipment will replace old machinery which currently has a book value of 100,000 and one year to go before it is fully depreciated. The new equipment will be depreciated straight line to zero over five years with no salvage value at the end of its life. If the project is undertaken, the old equipment will be sold for 40,000.

SPI will sell the speakers to the wholesalers for 110 each and they will cost a total of 75 each to manufacture and distribute. At the start of the project it is expected that there will be 150,000 of stock required. At the same time accounts receivables will be 80,000 and accounts payable 40,000. These levels will be maintained until the end of the project. The company expects to sell 50,000 units in the first year, rising to 60,000 in year 2, 70,000 in year 3, 80,000 in year 4 and 75,000 in the final year.

A specialist technician from the parent company will be seconded to work on the project; her current salary is 65,000. The parent company will hire two new people on a temporary basis to fill the vacant position in the parent company. The salary bill for the two new employees is expected to be 100,000 per annum. The specialist technician from the parent company is expected to return to her position at the end of the second year, which is when the temporary positions will end.

There will be a strong marketing push in the first year, which will incur an extra 150,000 in costs; this marketing spend will drop to 100,000 a year for the rest of the project. The parent company has allocated 200,000 of overheads for the project, although the project will only directly incur 20% of that amount in actual overheads. The company will pay interest payments of 500,000 per year; the interest on the extra borrowing because of the project will make up 50,000 of that figure.

The companys capital structure is made up of 35 million in equity and 15 million of debt. SPIs ungeared beta is 1.15 and the debt beta has been estimated as being 0.25. The project is not out of line with the size of projects taken in the recent past. The company faces a tax rate of 25%. Dividends have been paid to the owners and these have been growing at a rate of 5% recently. The risk-free rate of interest is 3.0% and the stock market risk premium is 6%.

a) Calculate the cost of capital for the project.

(6 marks)

(b) Lay out the cash flows for the project, with explanations of why you have included or excluded certain cash flows, and calculate the NPV. Should the project be accepted?

(12 marks)

(c) Why is inflation a problem in capital budgeting and how should it be dealt with? Give

an example of the problems inflation can cause in capital budgeting.

(6 marks)

(d) Discuss the tax impact on NPV if the management at SPI decided to reclassify the equipment as three-year equipment rather than five-year equipment. No calculations

are required.

(6 marks)