The Management of Buga LifePlc are considering buying a new machine in order to produce a new product called Katata with a life span of three years. The machine will cost ZMW2,000,000.00 with an estimated scrap value of ZMW700,000.00 after the product life. The Management is undecided as to whether to finance the project using retained earnings or issue ordinary shares. The company expects to produce 90,000 units per annum of Katata which will be sold for ZMW25 per unit in the first year and subsequently increase the price by 8% annually.

Production costs per unit (at current prices) are as follows: material cost will be at ZMW9.5 and labour cost willZMW7.5. Materials are expected to inflate at 7.5% p.a. and labour is expected to inflate at 6% p.a. Fixed overheads of the company currently amount to ZMW1,100,000.00 per annum. The Management Accountant has decided that 20% of these fixed costs should be absorbed into the new product (Katata) per annum. An additional ZMW500,000.00 of working capital will be required at the start of the project.

Capital allowances are available for the machine at 25% per year on a reducing balance basis.Corporate tax is 30% payable one year in arrears.

Buga LifePlc is financed by 70% equity and 30% debt. The debt consists of a 10% bond with a six-years to maturity issued at a nominal value of ZMW1,000. The current market value of the bond is ZMW1, 031 per ZMW1,000. The equity premium is 7% and Buga LifePlc asset beta is 0.9. The five-year government bond yield is 6%. Corporate tax is 30% per year. Calculate the weighted average cost of capital (WACC) of the business.

Required:

1. Calculate the Weighted Average Cost of Capital (WACC) for Buga Life Plc. (10 marks)
2. Calculate the NPV of the proposed investment in the new machine and advise Buga Life Plc as to whetheror not the investment should be accepted. (15 marks)
3. Discuss the reasons why the Buga Life Plc would finance the project using retained earnings rather than issue ordinary shares. (5 marks)
4. Discuss the conflict that would arise between the shareholders and the company managers of Buga Life Plc and suggest mitigation measures that would help to minimize them. (10 marks)

[Total = 40 Marks]