Green Star Acoustics Limited (GSA) is a medium-sized quoted manufacturing company based in Scotland that makes highly specialised audio equipment. The Board of Directors is considering a project where GSA will manufacture novelty wireless speakers (‘Contract Speaker’).

The information provided by the Board of Directors on this new project is as follows:

1. Contract Speaker will involve GSA purchasing new equipment. This will cost £1 million, and there will be an extra £200,000 of capital installation costs. The new equipment and the capital installation costs both attract capital allowances (tax depreciation) on a straight line basis. The equipment will have no salvage value at the end of its life.

2. If the Contract Speaker project is undertaken, old equipment will be sold for £70,000.

3. GSA will sell the speakers to the wholesalers for £22 each in Year 1 and this price will be inflated by 2% each year, starting in Year 2. GSA expects to sell 70,000 units in Year 1, rising to 75,000 in year 2, 80,000 in year 3, 90,000 in year 4 and 80,000 in the final year.

4. The speakers will have a variable cost of £15 each in Year 1 and this cost will increase by 3% each year starting in Year 2.

5. A specialist technician currently working for GSA will be seconded from her current project (Contract Gartmore) to work on Contract Speaker for the first two years. Her current salary is £65,000 per annum. GSA will require to hire two new people on a temporary basis to perform her current work on Contract Gartmore for two years whilst she is seconded to Contract Speaker. The salary bill for the two new employees is expected to be £100,000 per annum. The specialist technician is expected to return to her position on Contract Gartmore at the end of the second year, which is when the temporary positions will end.

6. There will be a strong marketing push in the first year, which will incur an extra £90,000 in costs. This marketing spend will drop to £60,000 a year for the rest of the Contract Speaker project. GSA has allocated £200,000 of overheads per annum for the Contract Speaker project, although only 30% of this is in respect of incremental overheads.

7. GSA expects to pay interest of £250,000 per year over the next five years. The interest on the extra borrowing because of the Contract Speaker project will make up £40,000 of that figure per annum.

8. At the start of the project it is expected that there will be £75,000 of working capital required. This level will be maintained until the end of the project. The company pays corporate taxation at a rate of 22% and this is payable in the year it is incurred.

GSA’s capital structure comprises £25 million in equity and £10 million of debt. GSA’s equity beta is 1.37 and its cost of debt is 4.5% before taxation. The risk-free rate of interest is 3.0% and the average stock market return is 9%. calculated the NPV

Answer rating: 100% (QA)

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