Requirement 2 (6 marks): Evaluate the following project and make a capital budgeting decision by using net present value method, discounted payback period method and internal rate of return method:

Porthos Company, originally established in 1962 to make fencing foils, is now a leading producer of sports equipment. The management of the company has always sought to exploit opportunities in whatever businesses have potential for cash flows. The chief executive of Porthos Company, Mr. Dumas, has identified another segment of the sports equipment market that looks promising: the brightly-coloured snowboard. He believes that it would be difficult for competitors to take advantage of this opportunity based on style and appearance because of Porthoss cost advantages and because of its ability to use its highly developed marketing skills.

Consequently, the company decided to evaluate the marketing potential of the brightly-coloured snowboard. The market research, which cost 250,000, showed that the brightly-coloured snowboard could achieve a 10-15% share of the market.

The project would make use of an existing warehouse, which is currently rented to a neighbouring firm. Next years rental charge on the warehouse is 50,000, and thereafter the rent is expected to grow in line with inflation. In addition to using the warehouse, the project involves an investment in plant and equipment of 700,000. The plant and equipment has an estimated market value of 150,000 at the end of three years.

Production and sales by year during the three-year life of the machine are expected to be as follows: 50,000 units, 100,000 and 80,000 units. The price of the snowboard in the first year will be 24. The snowboard market is becoming highly competitive, so Mr. Dumas believes that the price of snowboards will increase at only 2% per year, as compared to the anticipated general inflation rate of 4% per annum. Conversely, the materials used to produce snowboards are rapidly becoming more expensive. Because of this, production costs are expected to grow at 10% per year. First year production costs will be 12 per unit. Mr. Dumas has determined, based upon Porthoss taxable income, that the appropriate corporate tax rate for the snowboard project is 20%.

Mr. Dumas believes that investment in working capital will be 20,000 in year 0. This is expected to increase to 40,000 in year 1 and 50,000 in year 2 before falling to zero at the end of the project. Working capital amounts are stated in nominal terms.

The companys debt to market value ratio is currently 20% and this is not expected to change if the project is taken on. The debt, which can be regarded as risk-free, attracts an interest charge of 100,000 per annum. The current risk-free rate on debt is 6% per annum and the market risk premium is 4%. The equity beta is 0.8.