QUESTION FOUR

Mr. Max, Chief Financial Officer (CFO) of Oly Garment Ltd, has been asked by the Chief Executive Officer (CEO) to help with their capital investment appraisal. The company has recently completed a feasibility study on whether to expand its market offerings to provide a specially designed high-quality Jacket for the men's clothing line. This would require an investment in capital infrastructure for the production line. Market research indicates no other competitors have ever sold this specially designed product before. It might open an entirely new market for Oly Garment Ltd.

In addition, the feasibility study revealed that the Jacket could be sold via an online trading system (e-trade). Based on the results of the feasibility study, Oly Garment has estimated that 122,000 Jackets can be sold annually over the next five years at a starting price of $68 for each Jacket. Given the fast-paced technology associated with high competition, Oly Garment's management believes the life cycle of the Jacket will be short and therefore, Oly will only be able to sell at $67 per Jacket for the first two years it is introduced into the market. Oly Garment will need to discount the price of each Jacket in years 3 and 4 to $64 and $62 for year 5. Variable costs are $45 per Jacket and total annual operating fixed costs are $325,000 per year.

The project cost includes $7,000,000 to extend Oly Garment's production facilities, which will be fully depreciated within the useful life of 5 years. Additional working capital specific for this project is estimated to be $150,000. At the end of the project working capital amount is estimated to $100,000 and returned to the cash flow at the end of the project.Oly Garment Ltd.'s CFO, Mr. Max, is not entirely certain about this project and would like your advice as Oly Garment have not sold via e-trading before. While the Jacket is expected to be attractive for men across the globe, Mr. Max is unsure about the level of risk the company will be exposed to with this project.

Consider that the expected rate of return is 11 percent and the applicable corporate tax rate for Oly Garment Ltd is 30 per cent.

REQUIRED:

1. What type of investment is Oly Garment Ltd making? Justify why you came to this conclusion.
2. Calculate the net present value (NPV) of the Jacket project. Ensure you show your workings.
3. Advise Mr. Max as to whether Oly Garment Ltd should proceed with the Jacket for the men's clothing line. Justify your recommendation.