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Sidkap Hard Rock is an Australian based company with majority of its shareholders being overseas residents in Slovenia, Madagascar, and the Caicos Islands. The company is considering the introduction of a new product to add to its current product range. The company is considered a pioneer in the manufacturing of 35-centimetre granite marble tiles, primarily used in floor furnishings.

The proposed product is a smaller 20-centimetre granite marble tile. A recent market survey undertaken by the company suggested a shift in consumer preference towards smaller sized floor tiles. The market survey was outsourced to well-known market research firm Come in Spinner Research for an up-front fee of $110,000. The board of directors of Sidkap Hard Rock believe that the new product will have a life of 5 years, after which the new product should be deleted from the range of products that the company sells.

The new product requires the company to purchase new “state of the art” equipment costing $400,000 (inclusive of freight and installation charges). The useful life of the equipment is 5 years, with an estimated salvage value of $157,500 at the end of the 5-year life. The equipment is to be depreciated for accounting and taxation purposes on a straight-line basis over 5 years to zero value.

The new product will be manufactured in a factory already owned by the company. The factory originally cost $250,000 to build and has a current resale value of $350,000. The factory is currently being rented to another company under a lease arrangement that has 5 years to run and provides for an annual rent of $20,000. Pursuant to the lease agreement, Sidkap Hard Rock can cancel the lease at any time by paying the lessee compensation equal to 1 year’s rental payment. If this option is taken up by Sidkap Hard Rock the cancellation fee would be payable to the lessee

immediately upon cancellation.

It is also expected that the new product will require a one-off promotional campaign at a cost of $60,000 to be incurred as soon as the project is accepted. Working capital of $22,500 will be needed at the commencement of the project to fund the initial inventory. The working capital outlay is expected to be fully recoverable at the end of the project.

Other than the items mentioned above which are all assumed to be tax-deductible (other than the purchase cost of the machine and the initial working capital), the new product is expected to generate the following before-tax net cash flows (which are all assumed to be subject to Australian company taxation):

Year 1: Year 2: Year 3: Year 4: Year 5:

$260,000 $250,000 $330,000

$330,000 $190,000

The board of directors of the company have assessed that the sales of the 20- centimetre granite marble tiles will “eat-into” the sales of the 35-centimetre granite marble tiles. As a conservative estimate, it is believed that 10% of the projected sales of the 20-centimetre granite marble tiles will be a result of sales diverted from of the 35-centimetre granite marble tiles.

Given the various taxation conditions that the firm operates within, assume that the company tax rate is 36% with taxation paid in the year that net income is earned. It is also assumed that sales and expenses are received and incurred at the end of each year.

The company wants to finance this new project using debt and equity in the same proportion as its existing capital structure. The company’s shares are currently trading on the Australian Stock Exchange for $3.80 each with a total of 100 million shares on issue. The company shares have a beta of 1.5. The directors of Sidkap Hard Rock have a policy of retaining 50% of the company profits each year and have recently recommended the current payments to shareholders of a dividend of $1.05 per share. It is not expected that the dividend policy of the company is likely to change soon.

Sidkap Hard Rock also has issued 1 million 5-year bonds (each with a face value of $100) with annual coupon payments in arrears at an interest rate of 9% per annum. The bonds are currently trading at a pre-tax yield of 7.8% per annum.

In addition to that shown above, the following financial information has been collected by the company’s finance department:

• The yield on short-dated government securities is expected to be a

constant 7% perannum over the following 5-year period.

  • The Australian economy is expected to achieve an average annual

    growth rate of 3%over the next 5 years.

  • The average geometric return on the relevant share index (ASX200) is

    expected to be15% per annum over the next 5 years.

Required:

i) Whether analysis of this capital budgeting proposal should be

undertaken on abefore-tax or after-tax basis.
ii) Calculating the initial, differential, and terminal cash flows.

iii) Setting out any assumptions used.

iv) Calculating the WACC of the company.

v) Calculating the NPV of the capital budgeting proposal.
vi) Recommending the acceptance or rejection of the capital budgeting proposal.

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