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Question 3 Richard Ltd. is a manufacturer of data modems. It has recently hired a marketing consultant to carry out a feasibility study on a
Question 3 Richard Ltd. is a manufacturer of data modems. It has recently hired a marketing consultant to carry out a feasibility study on a new 4-year project to manufacture USB-Modems for the export market. Richard owns an industrial property that was bought 2 years ago at a cost of $1.4 million for investment purpose, and its original plan was to sell the property at the current market value of $1.258 million on an after-tax basis. Since the new project will be occupying the premises, the company now plans to sell the property only at the end of 4 years, but at an estimated value of $1.45 million on an after-tax basis. The new project also requires $480,000 investment in fixed assets, which have an estimated salvage value of $45,000 before tax at the end of the project. The assets will be depreciated fully on a straight line basis over 4 years (ignore salvage value when computing annual depreciation). Annual sales generated from this project are estimated as follows: Year 1 sales 2,500,000 Year 2 sales 3,500,000 Year 3 sales 3,200,000 Year 4 sales 4,200,000 Total annual operating costs (not including depreciation) are estimated to be 55% of sales. Due to this new project, the company's current assets will increase by $120,000, and accounts payable will also increase by $50,000. Other current liability items do not change. The increase in net working capital is expected to be completely recovered at the end of the project. The project will also cause its after-tax cash flows from its desktop modem products to increase by $30,000 per year. Richard's marginal corporate tax rate is 30%. (a) Compute the relevant annual cash flows (i.e. cash flow for Year Oto Year 4) for evaluating this new project (12 marks) (b) Richard's common shares are currently trading at $40.5 per share. The next common share dividend is expected to be $2.80 per share. Annual dividend growth rate is expected to be constant at 6.5% perpetually. Its outstanding quarterly-coupon bonds, with par value of $850 and coupon rate of 6.8%, are currently traded at $850. The bonds still have 6 years to maturity. The company has no preferred stock. Richard's target capital structure is 35% debt and 65% equity. Compute the NPV of the USB- Modem project. (8 marks)
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