Question 7

(a) Jose and Louis run a clothing manufacturing company and are considering expanding their business to include manufacturing and printing customised football jerseys. Neither knows much about football or finance. Knowing that you have recently completed a finance class, they ask you for advice on whether or not to undertake this project. They have provided you with the following information. They project unit sales of the football jerseys will be 5,000 in the first year, with growth of sales of 15 per cent each year for the next five years. Production of the jerseys will require 28,000 in net working capital to start. Total fixed costs are 75,000 per year while variable costs are 20 per jersey. Each jersey will have a selling price of 45. An initial up front cost of 60,000 will be required to purchase a new machine to manufacture and print the jerseys. The equipment is to be depreciated using the reducing balance method of depreciation and it not expected to have any salvage value. The rate of depreciation to be used is 20%. The tax rate the company faces is 25% and in order to invest in the project, Jose and Louis require a rate of return of 22%. Write a report to Jose and Louis advising them whether or not you would recommend investing in this project. Show three investment evaluation techniques (NPV analysis, profitability index and ordinary payback period) to support your recommendation. If the required rate of return fell to 12%, would your recommendation change? Explain why or why not. (28 marks)

(b) Explain what is meant by Type I agency costs and Type II agency costs. If a country has a bank-based financial system, would you be more concerned or less concerned Page 4 of 5 about Type I agency costs than in a country that has a market based financial system? Explain your answer.