Question

Fantastical Dreamers CC has come up with a new product, called TGTSSB (aka The Greatest Thing Since Sliced Bread), and are trying to decide whether to put it into production. Their production manager has calculated that it would cost R500,000 to set up the production line to start making the product. Their market research has indicated that they can expect net cash inflows of R300,000 in the first year, R150,000 in each of year two and three, and R100,000 in each of year four and five. After five years, they feel the product will be obsolete, and will no longer be viable to produce and sell. Their business is half funded by preference shareholders, who require a 12% return, and half funded by ordinary shareholders, who require a 16% return. 2.1 Using the information given, what is the payback period of the project? (Max. 5 lines) Start writing here: 2.2 What is the net present value of the project? Calculate your answer by filling in the table below: Year Net cash flow PVIF PV of net CF Total PV of cash flows Less initial investment NPV

Answer 1

It is stated that the business is half funded by preference shares and half funded by ordinary shares.

Weighted Average Cost of Capital (WACC)= Wp*Rp + We*Re

Where Wp= Weight of preference shares (50%), Rp= Cost of preference shares (12%), We = Weight of ordinary share capital (50%) and Re= Cost of ordinary share capital (16%)

Substituting the values, WACC= 50%*12% + 50%*16% = 14%

Part 2.1:

Ordinary payback period= 2.33 years

Using WACC as discount rate, discounted pay back period= 3.34 years

Details of calculation as follows:

7 ДА В 1 Pay back period 2 3 4 Rate of return required (r) 14% 5 Initial investment in year 0 500,000 6 All amounts in R Given values Present Value Investment to Investment to 8 Year (t) Cash flow (C) be recovered Formula Cell ref Value be recovered 9 (500,000) 1 300,000 (200,000) C/(1+r) B10/(1+C10) 263,157.89 (236,842.11) 11 150,000 (50,000) C/(1+r)^2 B11/(1+C11)^A11 115,420.13 (121,421.98) 150,000 100,000 c/(1+r)^3 B12/(1+C12)^A12 101,245.73 (20,176.25) 100,000 200,000 c/(1+r)^4 B13/(1+C13)^A135 9,208.03 39,031.78 14 100,000 300,000 C/(1+r)^5 B14/(1+C14)^A14 51,936.87 90,968.65 15 16 17 Pay back period Ordinary Discounted 18 Last whole year of recovery 19 Balance after last whole year of recovery 50,000 20,176.25 20 Next year recovery 150,000 59,208.03 21 Fraction of pay back year D24/D25 0.333333 G24/G25 | 0.340768811 22 Total pay back period years D23+D26 2.333333 G23+G26 3.340768811 12 13

Part 2.2:

Net Present Value of the project=   R 90,968.65 calculated as follows:

D 5 D12 =D10-D11 A B C 1 2 Discount rate (WACC) 14% 3 Year Net Cash Flow PVIE PV of net CF 4 (t) CF 1/(1+r)^t CF*PVIF 1 300,000 0.877192982 263,157.89 150,000 0.769467528 115,420.13 150,000 0.674971516 101,245.73 100,000 0.592080277 59,208.03 5 100,000 0.519368664 51,936.87 Total PV of Cash flow SUM(D5:09) 590,968.65 11 Less: Initial investment 500,000.00 12 NPV 90,968.65 7 AWN 10

Part 2.3:

Profitability index is calculated by dividing Total PV of cash flows by the amount of initial investment.

The profitability index of the given project= 1.1819

Details as follows:

D12 Ja =D10/D11 в с D 1 2 Discount rate (WACC) (r) 14% 3 Year Net Cash Flow PVIF PV of net CF 4 (t) CF 1/(1+r)^t CF*PVIF 300,000 0.877192982 263,157.89 150,000 0.769467528 115,420.13 3 150,000 0.674971516 101,245.73 100,000 0.592080277 59,208.03 100,000 0.519368664 51,936.87 10 Total PV of Cash flow SUM(D5:09)= 590,968.65 11 Initial investment= 500,000.00 12 Profitability index= Total Pv/Initial Investment 1.1819 9

Part 2.4:

NPV is positive at R 90,968.65 as shown in part 2.2

Profitability index is higher than 1 as shown in part 2.3

Hence they should go ahead with putting into production.