Amadeus Corporation is considering the issue of a new product to be added to its

Question

Amadeus Corporation is considering the issue of a new product to be added to its product mix. They hired you, a recent business graduate from MacEwan, for conducting the analysis. The production line would be set up in an unused space at the company’s main plant. The plant space could be leased out to another firm at $15,000 per year starting from year 1. They should buy new machinery. The approximate cost of the machine would be $160,000, with another $16,000 in shipping and handling charges. It would also cost an additional $24,000 to install the equipment. The machinery has an economic life of 5 years and would be in Class 8 with a CCA rate of 35%. The machinery is expected to have a salvage value of $90,000 after 5 years of use. The new product line would generate incremental sales of 1,500 units per year for 5 years and they are expected to grow 4% per year. The cost per unit is estimated in $60 per unit in the first year. Each unit can be sold for $210 in the first year. The sales price and cost per unit are both expected to increase by 3 % per year due to inflation. The fixed costs are estimated to be $90,000 at the end of 1st year and would increase with inflation. To handle the new product line, the firm’s net operating working capital would be an amount equal to 17% of sales revenues. The firm tax rate is 35%. There are 1000 common shares outstanding with market price of $40 each. Also, they have 100 preferred shares with market value of $50. There are $50,000 long-term bond trading in market with an average price of $1,100 and 6 years to maturity, and 8% semi-annual coupon. Common shares of firm have a beta of 1.3. Risk free rate is 4% and expected market return is 16%. Preferred stock holder are receiving 1 dollar quarterly dividend. The project is considered by the financial department to be as risky as the company. The reinvestment risk is assumed to be 15%.

Explanation / Answer

For analysing whether the project should be considered, I am using the NPV of the project. If the NPV of the project is greater than 0, the project is profitable and should be considered.

Calculation of depreciation (ignoring half year rule)

Calculation of salvage net of tax

Equity Cost of Capital = Rf + Beta(Rm-Rf) = 0.04+1.3(0.16-0.04) = 19.60%

Cost of Preference Capital = Div per annum/Market Price = (1*4)/50 = 8.00%

Cost of Debt (Yield to maturity) = [Interest per period +((Par Value - Market Price)/Periods to maturity)] / [(Par+mkt value)/2] * [no. of payments per year] = [(8%/2*1000)+((1000-1100)/12)] / [(1000+1100)/2] * 2 = 6.04%

WACC = (% of debt)(After-tax cost of debt) + (% of preferred stock)(cost of preferred stock) + (% of common stock)(cost of common stock)

Conclusion: SInce the project has +ve NOV, the project is profitable and should be accepted in the product mix.

Step 1: Calculation of PAT and operating cash Flow Year 1 2 3 4 5 Units 1,500 1,560 1,622 1,687 1,755 Sale Price pu 210 216 223 229 236 Cost pu 60 62 64 66 68 Sales 315,000 337,428 361,453 387,188 414,756 Variable costs (90,000) (96,408) (103,272) (110,625) (118,502) Gross Profit 225,000 241,020 258,181 276,563 296,254 Fixed Costs (90,000) (92,700) (95,481) (98,345) (101,296) Depreciation (70,000) (45,500) (29,575) (19,224) (12,495) PBT 65,000 102,820 133,125 158,994 182,464 Tax @35% (22,750) (35,987) (46,594) (55,648) (63,862) PAT 42,250 66,833 86,531 103,346 118,601 Depreciation 70,000 45,500 29,575 19,224 12,495 Operating CF 112,250 112,333 116,106 122,570 131,096

Calculation of depreciation (ignoring half year rule)

Cost of machinery 160,000 Shipping and Handling 16,000 Installation charges 24,000 Depricable amount 200,000

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