Mercury Go ple manufactures specialist hard shell travel bags for young children, mostly designed in shapes...

 

  

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Mercury Go ple manufactures specialist hard shell travel bags for young children, mostly designed in shapes attractive to children. They are small enough to count as cabin luggage for most airlines (but not all of them). Demand this year is strong for the product and Mercury Go's travel bag production line is operating at its capacity of 10 million travel bags per year, which are sold all round the world. Sales could reach 11 million next year if Mercury Go had the productive capacity. An analysis carried out by the marketing team at the company has predicted unit sales figures of 11m, 12.5m, 14m, 15m and 15.5m over the next five years if Mercury Go spent an extra £1,500,000 per annum on advertising and marketing in each of the first three years and Im per year for the final years. To achieve this would need an investment in extra productive capacity. The new equipment would cost 750,000, and there would be (60,000 of capitalised installation costs and 30,000 of expensed installation costs. The equipment would be depreciated straight line to zero over four years. The life of the equipment could be extended to five years if Mercury Go overhauled the equipment at the end of year 4. The overhaul would be expected to cost £170,000 and this cost would be expensed at the time it was carried out. The company has apportioned £80,000 of overheads to the project. The salvage value of the equipment at the end of five years is expected to be £50,000, The wholesale price of the travel bags is 4.80 each and there are variable costs of £2.95 per case Extra investment in working capital would be needed at the start of the expansion project. This would amount to £175,000 and working capital would be maintained at the 175.000 level through until the end of the project. There are also interest payments of £85,500 per year through the life of the project and equipment removal costs at the end of the project of £25,000. The company has a target capital structure with 25% deht. This is a rounne project for Mercury Go. The debt has a beta of 0.30 and the company has an ungeared beta of 1.40. The risk-free rate of interest is 5% and the market risk premium is ts. The tax rate is 25% () (b) (C) Calculate the cost of capital for the project. (5 marks) Lay out the relevant cash flows for the project and calculate the NPV. What should the company do? (10 marks) The management team is also considering an alternative to the expansion project. The Finance Director has suggested a wholesale price increase from £4.80 to (5.50 per case. Under this scenario demand would be assumed to fall by 10% from the current level to 9m units for the first three years and then return to the level prevailing before the price rise for the last two years. If this option were chosen, there would be extra maintenance and operating costs of (80,000 per year and an extra (120,000 marketing costs per year, but no extra working capital, and there would be no need to undertake the expansion project. What is the value of this alternative? What should the company do? (7 marks) List four mistakes that might be made in capital budgeting and explain fully how they should be treated. (8 marks) Total 30 marks Mercury Go ple manufactures specialist hard shell travel bags for young children, mostly designed in shapes attractive to children. They are small enough to count as cabin luggage for most airlines (but not all of them). Demand this year is strong for the product and Mercury Go's travel bag production line is operating at its capacity of 10 million travel bags per year, which are sold all round the world. Sales could reach 11 million next year if Mercury Go had the productive capacity. An analysis carried out by the marketing team at the company has predicted unit sales figures of 11m, 12.5m, 14m, 15m and 15.5m over the next five years if Mercury Go spent an extra £1,500,000 per annum on advertising and marketing in each of the first three years and Im per year for the final years. To achieve this would need an investment in extra productive capacity. The new equipment would cost 750,000, and there would be (60,000 of capitalised installation costs and 30,000 of expensed installation costs. The equipment would be depreciated straight line to zero over four years. The life of the equipment could be extended to five years if Mercury Go overhauled the equipment at the end of year 4. The overhaul would be expected to cost £170,000 and this cost would be expensed at the time it was carried out. The company has apportioned £80,000 of overheads to the project. The salvage value of the equipment at the end of five years is expected to be £50,000, The wholesale price of the travel bags is 4.80 each and there are variable costs of £2.95 per case Extra investment in working capital would be needed at the start of the expansion project. This would amount to £175,000 and working capital would be maintained at the 175.000 level through until the end of the project. There are also interest payments of £85,500 per year through the life of the project and equipment removal costs at the end of the project of £25,000. The company has a target capital structure with 25% deht. This is a rounne project for Mercury Go. The debt has a beta of 0.30 and the company has an ungeared beta of 1.40. The risk-free rate of interest is 5% and the market risk premium is ts. The tax rate is 25% () (b) (C) Calculate the cost of capital for the project. (5 marks) Lay out the relevant cash flows for the project and calculate the NPV. What should the company do? (10 marks) The management team is also considering an alternative to the expansion project. The Finance Director has suggested a wholesale price increase from £4.80 to (5.50 per case. Under this scenario demand would be assumed to fall by 10% from the current level to 9m units for the first three years and then return to the level prevailing before the price rise for the last two years. If this option were chosen, there would be extra maintenance and operating costs of (80,000 per year and an extra (120,000 marketing costs per year, but no extra working capital, and there would be no need to undertake the expansion project. What is the value of this alternative? What should the company do? (7 marks) List four mistakes that might be made in capital budgeting and explain fully how they should be treated. (8 marks) Total 30 marks

Answer rating: 100% (QA)

a The cost of capital for the project is W ACC 0 25 x 0 30 x 5 0 75 x 1 40 x 0 05 0 075 0 10 0 175 or 17 5 b The relevant cash flows for the project a... View the full answer