Question

Please list all your working. Thank you!!

Question 2: Capital Budgeting (20 mins)

After a long successful career as both a wizard and a broomstick retailer, an aged Harry Potter decides to set up a shop called Harry’s Hairpieces to cover up his bald spot. Due to recent trends in demand, he has considered introducing a new hairpiece, the Trump Deluxe. He has spent $2 million to date in developing and testing the product, and spent $50,000 paying summer interns who gathered further market data to assist him with his decision. The new product would be sold for three years, with demand falling to 0 by 2020. Total revenue from the product is expected to be $1 million for the first year and increase by 5% over years two and three. Demand for the Trump Deluxe is expected to come at the expense of purchases of existing products. The effect of this has been approximated at $100,000 in the first year and will increase by 3% p.a. Producing the Trump Deluxe will incur additional operating expenses of $600,000 every year and also require additional working capital of $100,000 at the beginning of the project (but will be recoverable in the end). Upon receiving the go-ahead, the production team can immediately purchase the required machinery to commence production of the hairpiece. The machinery will cost $1 million and can be sold at the end of the project for $800,000. For tax purposes, the machinery has a depreciable life of ten years, depreciated at a straight-line basis with no residual value. Please note that the above dollar figures are all stated in nominal terms. The inflation rate is expected to be 2% for the next three years. The store also currently faces a company tax rate of 30%. Assume the company has a real WACC of 15%. Advise the company.

Answer 1

NOTE: Real WACC = 15 % and Inflation = 2 %. As the cash flows are given in nominal terms or constant dollar terms, the discount rate should also be in nominal terms. Therefore, nominal WACC = (1+Real WACC) x (1+Inflation) = 1.15 x 1.02 = 1.173 or 17.3 %. Further, the product development and testing costs along with the stipends paid to summer interns were incurred as part of deciding whether to go ahead with the product. Hence, even if the decision was to not go ahead (in case of low expected demand, product failure at the testing phase, product development failure, etc) with the product, these costs would have been irrecoverable, thereby making them sunk costs. Sunk Costs are not considered in capital budgeting analysis.

As the NPV of the project is positive, the company should go ahead with the project.