(Cost of capital, capital budgeting, capital budgeting: adjusting for risk and inflation)
Blocks Ltd faces a decision about a new mould to be used for the manufacturing of bricks. The management of the company needs advice to reach a decision on this purchase as the strategy it wants to follow would require the new mould. However, it is not willing to accept an unprofitable, lengthy or overly risky investment at this point in time.
Currently the company is financed solely through equity but has access to a credit facility at an 8% before-tax cost of debt. The company has R2 000 000 in retained earnings to be used before the credit facility is used. The current cost of equity for the company is 12% and the company is taxed at 30%.
The mould will have a life expectancy of four years. It will cost R6 000 000 to purchase and R1 000 000 to deliver and install. The purchase of the mould and putting it to use will lead to an increase of R1 000 000 in net operating working capital (NOWC).
Year Sales generated
1 R2 500 000
2 R3 500 000
3 R4 000 000
4 R2 000 000
The mould will be sold for use at a price of R500 000 at the end of the four-year period. Capital gains are taxed at the 30% rate.
The mould will require overheads of R200 000 per year and variable costs will amount to 20% of sales for each year.
Depreciation takes place on a straight-line basis over the course of the life of the mould.
Required:
- Determine the NPV, IRR and MIRR of the mould.
- Also determine the NPV of the machine using the real rate of return method to adjust for inflation of 5% and assuming risk premium of 1,2 is applied.
- Evaluate the decision and provide a brief report on the acceptability and risk of the project.