QUESTION 2 20 marks Wagon Ltd produces bespoke horse drawn wagons for parks and operates in the leisure sector The company is in the process of deciding whether it should invest in a new machine to expand its production capabilities and expand horizontally The new machine will allow the company to also manufacture household furniture for which a large market exists Currently, the company has a beta of 1 2 associated with its shares while the beta of the household furniture sector is 2 0 The risk free rate is 3 while the market risk premium is estimated at 6 Inflation is projected to remain at the current 2 for the foreseeable future The company is wholly financed by equity To obtain, install and get the machine up and running will cost R5 000 000 Projected operating cash flows presented in real terms (that is, inflows after variable and fixed costs had been subtracted, but not tax or working capital requirements and unadjusted for inflation) generated by the project are as follows Item Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Sales R0 R1 000 000 R1 000 000 R1200 000 R1 500 000 R2 000 000 The CFO of the company has indicated that they prefer to adjust cash flows for inflation by inflating them to nominal cash flows It is expected that an outlay of R500 000 in working capital will be required but can be recouped at the end of the life of the machine The machine has an expected life of five years and can be depreciated over a course of its life by way of the straight line method At the end of the machine's life, it is expected that the company will be able to sell it for R100 000 A tax rate of 28 is applicable and capital gains are taxed on 67 of the capital gain Required Perform a net present value analysis on the project (14 marks), indicate the acceptability (1 mark) of the project and briefly summarise your findings regarding the viability of the project, the effect of risk on the project and the effect of inflation on the analysis, in such a manner that it would assist the decision makers with their choice (5 marks)

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QUESTION 2 [20 marks] Wagon Ltd produces bespoke horse-drawn wagons for parks and operates in the leisure sector. The company is in the process of

QUESTION 2 [20 marks]

Wagon Ltd produces bespoke horse-drawn wagons for parks and operates in the leisure sector. The company is in the process of deciding whether it should invest in a new machine to expand its production capabilities and expand horizontally. The new machine will allow the company to also manufacture household furniture for which a large market exists.

Currently, the company has a beta of 1.2 associated with its shares while the beta of the household furniture sector is 2.0. The risk free rate is 3% while the market risk premium is estimated at 6%. Inflation is projected to remain at the current 2% for the foreseeable future. The company is wholly financed by equity. To obtain, install and get the machine up and running will cost R5 000 000.

Projected operating cash flows presented in real terms (that is, inflows after variable and fixed costs had been subtracted, but not tax or working capital requirements and unadjusted for inflation) generated by the project are as follows:

Item	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Sales	R0	R1 000 000	R1 000 000	R1200 000	R1 500 000	R2 000 000

The CFO of the company has indicated that they prefer to adjust cash flows for inflation by inflating them to nominal cash flows.

It is expected that an outlay of R500 000 in working capital will be required but can be recouped at the end of the life of the machine. The machine has an expected life of five years and can be depreciated over a course of its life by way of the straight-line method. At the end of the machine's life, it is expected that the company will be able to sell it for R100 000. A tax rate of 28% is applicable and capital gains are taxed on 67% of the capital gain.

Required:

Perform a net present value analysis on the project (14 marks), indicate the acceptability (1 mark) of the project and briefly summarise your findings regarding the viability of the project, the effect of risk on the project and the effect of inflation on the analysis, in such a manner that it would assist the decision makers with their choice (5 marks).