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FoneBuzz Ltd, an
Australian manufacturer of lightweight tablet computers, is considering expanding
its Australian operation into producing tablet computers. The Chief Financial
Officer (CFO) of the company, Ms Michelle Smith, believes there will be
significant opportunities for growth for the company in the tablet computer
market and is therefore looking to construct a new manufacturing plant in
Sydney. FoneBuzz Ltd has not manufactured tablet computers before but they have
extensively researched the market and believe they can compete successfully.

  For this expansion Ms Smith has two options. The first option,
Plant A, is a highly automated process that involves significant capital
outlays but has lower running costs. Plant B is a more labour intensive
facility that has lower initial capital outlays but higher running costs. Plant
A and Plant B are mutually exclusive projects. 
As Ms Smith’s assistant you have been asked to prepare an analysis of
the projects to enable her to make a recommendation to the board of directors.
To assist your evaluation Ms Smith has provided you with the following
information:

i)
 
Sales for Plant A tablet computers amount
to 145,000 units per year, starting next year, with sales increasing in line
with economic growth.   Sales for Plant B tablet
computers amount to
78,000
units per year, starting next year, with sales increasing in
line with economic growth.  

ii)
 
The Plant A tablet computer has a
selling price of $300 next year, increasing in line with inflation.   The Plant B tablet computer has a selling
price of
$460 next
year, increasing in line with inflation.

iii)
 
The nominal economic growth rate is
projected to be 5% per year.

iv)
 
Both proposals are expected to remain
in operation for 5 years. At the end of the fifth year the machinery will be
sold for 15% of its initial value.   The land
and buildings will be retained by the company. 

v)
 
Last year, FoneBuzz Ltd. paid MacBank $120,
000 for a feasibility study that confirmed the manufacturing expansion was
economically viable.  

vi)
 
The machinery is considered depreciable
for tax purposes and will be depreciated using a straight line depreciation
method down to its salvage value. The land, buildings and furnishings are not
depreciable for tax purposes.

vii)
 
Plant A will require a provision of ($2,015,000)
in working capital and Plant B will require a provision of ($3,015,000) in
working capital. These requirements will remain unchanged over the life of the
plants.

viii)
 
There will be additional Sales and
Marketing expenses if the project goes ahead. Annually, Project A will incur $350,000
and Project B will incur $2,000,000.  

ix)
 
Head Office expenses will not
increase.   However, a fixed allocation of
$150,000 per year will be charged to whichever project goes ahead.

x)
 
All operating
expenses
are expected to remain constant.

xi)
 
FoneBuzz Ltd. is subject to a tax rate of
30%.   Tax is paid in the year after it is
incurred. [Do not make any other assumptions about the company’s tax liability.]

xii)
 
Both proposals are considered not to be in line with the
company’s core business and are of different risk.   FoneBuzz
Ltd
.’s realWACC is 8.60%. 
The nominalWACC used by the Computer Tablet industry is
10%. 

xiii)
 
Inflation is projected to be 3% per
year for the five year period.

Other
information:

 

Plant
  A

 

 

Plant
  B

 

 

Initial
  Costs:

 

*  Land

 

*  Buildings

 

*  Machinery

 

*  Furnishings and fittings

 

 
 

$12,500,000

 

$84,050,000

 

$26,150,000

 

$3,459,000

 

 

Initial
  Costs:

 

*  Land

 

*  Buildings

 

*  
 
Machinery

 

*  Furnishings and fittings

 

 
 

$12,500,000

 

$71,050,000

 

$10,150,000

 

$3,459,000

 

 

Operating expenses:

 

*  Fixed costs

 

*  Variable costs per unit

 

*  Labour costs per unit

 

 
 

$900,000

 

$21.80

 

$14.20

 

 

Operating expenses:

 

*  Fixed costs

 

*  Variable costs per unit

 

*  Labour costs per unit

 

 
 

$800,000

 

$35.80

 

$25.00

 

Required:

  1. Calculate
         the NPV and the IRR of Plant A and Plant B; and explain whether the
         ‘systematic risk’ of Plant A and Plant B has been priced into the
         NPV.     10 marks
  2. Explain
         whether the NPV and the IRR methods of project evaluation satisfy the
         objective to maximise shareholder wealth.  
         To what extent does the NPV, and the IRR decision, depend on the
         Capital Market operating efficiently?    
    10 marks

Assessment Criteria:

 

Learning Outcomes

 

 

Possible Marks

 

 
  1.   
  2. Appraise and
           compare investment projects using
  3.  

 

investment
  evaluation techniques

 

  1.   
  2. Show an understanding of the discounted
           cash flow method of asset valuation
  3.  

 

 

10 marks

 

 
  1.   
  2. Assess the information exchange effect of a corporation and the
           market
  3.   
  4. Show an understanding of the application of the Efficient Market
           Hypothesis
  5.  

 

 

10 marks

 

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