Case Study

Koda Private Limited ("Koda"), a privately owned company, has been manufacturing electrical parts used in mobility vehicles for people with disabilities and the elderly for more than two decades. These parts are exported to various manufacturers worldwide but at present there are no local manufacturers of mobility vehicles in Singapore.

Retailers in Singapore normally import mobility vehicles and sell them at an average price of $4,000 each. Koda wants to manufacture mobility vehicles locally and believes that it can sell vehicles of equivalent quality locally at a discount of 30% to the current average retail price.

Although this is a completely new venture for Koda, it will be in addition to the company's core business. Koda's directors expect to develop the project for a period of four years and then sell it for $16 million to a private equity firm. The local government has been positive about the venture and has offered Koda a term loan of up to 100% of the investment funds required, at market rates. Currently Koda can borrow at 3.0% above the five-year government debt yield rate.

A feasibility study commissioned by the directors, at a cost of $250,000, has produced the following information assuming a base case scenario:

1. Initial cost of acquiring suitable premises will be $11 million, and plant and machinery used in the manufacture will cost $3 million. Acquiring the premises and installing the machinery is a quick process and manufacturing can commence almost immediately.

2. It is expected that in the first year 1,200 units will be manufactured and sold. Unit sales will grow by 50% in each of the next two years before falling to an annual growth rate of 10.0% for the final year. After the first year the selling price per unit is expected to increase by 5.0% per year.

3. In the first year, it is estimated that the total direct material, labour and variable overheads costs will be $1,200 per unit produced. After the first year, the direct costs are expected to increase by an annual rate of 8.0%.

4. Annual fixed overhead costs would be $1 million. The fixed overhead costs will increase by 5.0% per year after the first year.

5. Koda will need to make working capital available of 15.0% of the anticipated sales revenue for the year, at the beginning of each year. The working capital is expected to be recovered at the end of the fourth year when the project is sold.

The firm's marginal tax rate is 17.0% per year on taxable profits. Tax is payable in the same year as when the profits are earned. Tax allowable depreciation is available on the plant and machinery on a straight-line basis and will be fully depreciated. It is anticipated that the salvage value attributable to the plant and machinery after four years is $400,000. No tax allowable depreciation is available on the premises.

Koda uses 8.0% as its discount rate for new projects but feels that this rate may not be appropriate for this new type of investment. It intends to raise the fill amount of funds through debt finance and take advantage of the government's offer of a subsidised loan. Koda's target debt-to-equity ratio is 0.25.

Although no other companies produce mobility vehicles in Singapore, GP Industries Limited ("GPI"). a company listed in Singapore Exchange, produces electrical-powered vehicles using similar technology to that required for the mobility vehicles and has been identified as a comparable guideline firm. Its historical beta is estimated by Reuters to be 1.25. The five-year government debt yield is currently estimated at 3.5% and the market risk premium at 6.0%.

Question 1

Compute Koda's weighted average cost of capital (WACC).

Question 2

Compute the future cash flows associated with the manufacturing of mobility vehicles and the net present value (NPV) of the project by filling in the blanks in the table below. Advise whether Koda should invest in this venture.

Question 3

Apply sensitivity analysis to evaluate the effect on net present value for the following situations. Compute the NPV respectively for 3 scenarios:

Scenario I: Fixed overhead costs in per annum is 20% higher than expected and will increase by 5.0% per year after the first year.

(ii) Scenario 2: Working capital required is 25.0% of the anticipated sales revenue for the year.

(iii) Scenario 3: At the end of the fourth year, salvage value of plant and machinery is $100,000 and divestment of project to private equity firm is 10% lesser than originally anticipated.