A company, Spice of Life Ltd, produces award-winning spices in grinders. It has been creative about the
Question:
A company, Spice of Life Ltd, produces award-winning spices in grinders. It has been creative about the combining of spices in the grinders. The products have been selling well in upmarket areas and the company is considering a new product line which reflects a new concept in the use of spices and will require the company to spend R2 million on initial promotion and test marketing at the current date, which is the end of 2021. If the test marketing phase of the project is successful, then the company will set up production in a year’s time, at the end of 2022, in a leased factory building at a cost of R6 million. This will be required to pay for equipment, fixtures, processes, and special storage facilities. There is a 67% chance that the test marketing phase will be successful. The new product line is expected to generate cash flows of R3.4 million per year for 4 years, from 2023 to 2026, when the concept is expected to become dated, and the product line will be deleted. If the test marketing is not successful, then the project will be abandoned. The company’s cost of capital is 12%. The expected residual value of the equipment, fixtures, and facilities in 5 years’ time is expected to be zero. Assume a zero-tax rate.
(a) Set out the decision tree diagram for the project.
(b) Determine whether the company should go ahead with the test marketing of the new product line.n