Chico Scroll Limited is a medium sized Australian manufacturing company whose shareholders cannot benefit from imputation credits. Its current capital structure comprises 100 million shares currently trading at $3.80 each, and $100 million face value (there are 1 million bonds on issue, each with a face value of $100) of 5 year bonds with yearly coupons payable at an interest rate of 10% p.a. The bonds are currently trading at a yield of 7.17% p.a. As the finance manager for the Chico Scroll Company you have to approve all new projects.
Recently the marketing department presented a proposal for a major new advertising campaign. It believes that a promotional campaign comprising print and TV advertising in the 2 weeks before Christmas 2004 costing $5m will yield increased sales over the next three years, translating into after-tax cash inflows of:
Year 1 $3,600,000
Year 2 $2,200,000
Year 3 $1,400,000
The finance manager has gathered the following financial information:
The current yield on 5 year government bonds is 5% p.a.
The historical return on the ASX sharemarket index has been 15% p.a.
Shares in Chico Scroll Limited have a beta of 1.4
The company pays tax at the rate of 30%
The company is able to raise funds through the placement of shares and bonds at current market values.
(a) Calculate the weighted average cost of capital (WACC) for the project and then calculate the net present value (NPV) to determine whether the company should accept or reject this project.
(b) How confident are you that your decision about the project is correct? Briefly detail which components of your evaluation you think may warrant further investigation and why.