PAF Plc is considering an opportunity to produce an innovative computer data storage device with a big capacity. It is expected that after four (4) years new technology will emerge rendering the device redundant. In addition, it is expected that after four years the environment will become uncertain. The annual demands are as follows:

YEARS	1	2	3	4
DEMAND IN UNITS (000)	100	250	200	90

The initial cost of this investment is K2 million payable immediately. The estimated selling price at current price is K15 per unit and unit variable costs is 30% of the selling price in the first year. Operational costs are expected to increase annually by 8% from year two. Selling price is expected to increase by 11% per year. Annual incremental fixed costs are estimated at K1million from the first year. PAF Plc has 11.8 million 50 ngwee shares trading at 250 ngwee each and bonds with book value of K11 million. The market value of bond is K1, 190 per K1000 par value. The companys after-tax cost of debt is 9.6% and asset beta is 0.91.

PAF Plcs capital structure is unlikely to change significantly following the proposed investment.

KLH Co manufactures computer electronic parts including the production of a data storage device similar to the one being considered by PAF Plc. KLH Cos overall equity beta is 1.35, and it is estimated that the equivalent equity beta for production of computer storage device is 1.10. KLH Co has 300 million 25 ngwee shares in issue trading at 220 ngwee each. Its debt finance consists of variable rate loans redeemable in seven (7) years. KLH Plc is financed by 75% equity and 25% debt. The risk free rate is 5% and market return is 15%. Both companies pay annual corporation tax at a rate of 30%.

Required:

1. Calculate the current weighted average cost of capital and the project specific cost of capital for PAF Plc. 15 MARKS
2. Evaluate the proposed investment in the computer data storage device using the net present value method. 15MARKS
3. Calculate the Internal Rate of Return (IRR) of the proposed project and advise if it is financially acceptable. 10 MARKS
4. Explain how the environmental uncertainty may impact the investment decision.

10 MARKS

[TOTAL: 50MARKS]