Question 3 Mr. Wong has a new product innovation to sell to any interested buyer. He receives an offer from a potential buyer who provides 2 alternatives to Mr. Wong: Alternative 1: He will receive 30% of the buyer's gross margin for the next 4 years. Buyer's projected sales for year 1 is $500,000 and it is expected to grow at 20% per year. Its gross margin is 60% of sales. Alternative 2: The potential buyer also offers an alternative to him to receive $120,000 now, plus an annual annuity of $X at the end of year 5 to year 10. Additionally, if the product sales of the buyer exceeds $5 million in cumulative sales by end of year 5, he will receive an additional $300,000 at the end of year 10. Mr. Wong estimates there is a 70% probability this will occur. If this does not occur, i.e., 30% probability, he will receive $50,000 at the end of year 10. Mr. Wong expected return from this investment is 5%. (a) What is the present value of Mr. Wong's return under Alternative 1? Show the relevant workings. Round up all the dollar values to the nearest dollars. (4 marks) (b) What is the value of $X under Alternative 2, which will make the two alternatives indifferent to Mr. Wong. Show the relevant workings. Round up all the dollar values to the nearest dollars. (6 marks) (c) Mr. Wong is also the CEO of Lotus Co. Now he is facing a decision on a new investment project. The project is for 4 years but requires the purchase of new equipment at the beginning. The equipment has a usable life of 5 years. The purchasing price is $1,250,000. Annual operating income before depreciation is expected to be $450,000 at the end of each year for 4 years. Its annual depreciation is $250,000 and salvage value will be $300,000. Market survey had already costed him $25,000. If he leases out the equipment, he will receive $50,000 yearly. The tax rate is 40%. Page 9 of 14 FINA2010 N/O/P Lotus Co. has an unleveraged beta of 1.3. This project will be funded by debt with a cost of 6,5%. The leverage now increases to 40% of debt and 60% of equity. Risk free rate is 3.8%, Market risk premium is 4.2%. Compute the NPV of the project and explain whether Mr. Wong should make this investment. (10 marks)