QUESTION 1 1.1. After extensive prototype development and test marketing, TechEl

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QUESTION 1 1.1. After extensive prototype development and test marketing, TechElectro plc believes it can penetrate the smart watch market. The firm is considering two alternative products. The first is TECH7 with built-in wifi. The second is TECH8 with both wifi and 4G. TECH7 would be introduced at a price of £400 per watch while TECH8 will be sold at £350 per watch. TECH7 is projected to sell 5000 pieces a year, whereas TECH8 would sell 10,000 pieces a year. Cash costs of production are expected to be £150 per watch for TECH7 which for TECH 8 are expected to be £170. Both products require further investment; TECH7 could be produced using new equipment costing £1 million. That equipment would last 3 years and have no resale value. The machinery required to produce TECH8 would cost £1.2 million and last 3 years. The firm expects the equipment for TECH8 to have a £100,000 resale value at the end of year 3. The firm uses the reducing balance (20%) depreciation. The firm faces a corporate tax rate of 24% and believes that the appropriate discount rate is 13%. By comparing the Net Present Value (NPV) for both projects, suggest which model of watch should the firm produce? (1 8%) 1.2. TechElectro, in the above question, is also considering another project. The project calls for a major renovation of the company's manufacturing facilities. The initial investment in the project is £5million while the incremental cash inflows in the first year are £1.5 million. Cash inflows are expected to increase by 10% every year for the next 3 years of the project's expected life. The risk of this project is higher than other projects and it is suggested that a 2% risk premium should be added to the cost of capital used for other projects. Calculate the Internal rate of return (IRR) to evaluate the project and indicate whether the project should be accepted or not. (8%)

Explanation / Answer

Required return = dicount rate + Risk premium = 13% + 2% = 15%

CF0 = -5

CF1 = 1.5

CF2 = 1.5*(1+10%) = 1.65

CF3 = 1.65*(1+10%) = 1.815

CF4 = 1.815*(1+10%) = 1.9965

IRR = IRR({-5,1.65,1.815,1.9965}) = 13.93%

IRR(13.93%) is lower than required rate(15%). Should not accept the project.

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