Question
Troubled Technology Ltd (TT) is a self-proclaimed worldwide leader in digital audio players. However, sales has been dismal, so TT is considering the production of
Troubled Technology Ltd (TT) is a self-proclaimed worldwide leader in digital audio players. However, sales has been dismal, so TT is considering the production of portable gaming consoles despite the greater business risk and stiff competition in this area. Nunchuk Company Ltd is an established player in the portable gaming industry with a market capitalization of about $40 billion and has just paid an aggregate of $2.6 billion in cash dividends, which has been increasing at 12% per year and likely to continue at this rate for the foreseeable future. Another major player in the portable gaming industry is XCube Inc, whose bonds trading at an average yield of 8% are almost as popular as the consoles that they produce.
For the venture under consideration, TT spent $750,000 to develop a prototype. The company has spent a further $200,000 for a marketing study to determine the expected sales figures for the new console. TT can manufacture the new console for $150 each in variable costs. Fixed costs for the operation are estimated to run $4.5 million per year. The estimated sales volume is 70,000, 80,000, 100,000, 85,000, and 75,000 for each of the next five years, respectively. The unit price of the new console will be $340. The necessary equipment can be purchased for $16.45 million and will be depreciated straight line to zero over seven years. It is believed the market value of the equipment will be $3.5 million in five years, when it is sold. Net working capital for the venture at the beginning of each year will be 20 percent of the sales revenue for that year.
TT has no traded debt, but is paying 6% in interest on $2 billion of existing bank loans. In addition, TT has 1 billion shares outstanding traded at a price of $4 each, with a beta of 1.2. The expected market portfolio return is 12%, and the risk-free return is 4%. Interestingly, manufacturers of digital audio players have similar capital structures to those of portable gaming consoles. The corporate tax rate is 35%.
(a) Calculate and justify a discount rate for the portable gaming console project under consideration. (8 marks)
(b)Find the relevant project operating cash flows for Year 0 to Year 5. (12 marks)
(c)Find the relevant project cash flow from assets for Year 0 to 5, compute the NPV of the project and advise whether TT should undertake the project. (10 marks)
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