Reference no: EM13365673
Question 1: Lonotek Limited ("Innotek") is a company listed on Singapore Exchange and manufactures data storage devices. One of its devices. the SMR-HDD. is produced exclusively for the Asian market. Innotek is considering ceasing the local production of the SMR-HDD gradually over a period of four years because it needs the manufacturing facilities used to make the SMR-HDD for other products.
The government of Indonesia is keen to develop its manufacturing industry and has offered Innotek first rights to produce the SMR-HDD and sell it to the Asian market for a period of four years. At the end of the four-year period, the full production rights will be sold to a government backed company for $3.0 million. No tax is payable on this proceeds.
Innotek has to decide whether to continue production of the SMR-HDD locally for the next four years or to move the production to Indonesia immediately.
Currently. each SMR-HDD unit sold makes a unit contribution of $20. This unit contribution is not expected to be subject to any inflationary increase in the next four years. Production and sales is estimated at 40.000 units in the first year and will fall by 20% each year for the following three years.
It is anticipated that after four years the production of SMR-HDD will stop. It is expected that the financial impact of the gradual closure over the four years will be cost neutral (i.e. the revenue from sale of assets will equal the closure costs). If production is stopped immediately, the excess assets would be sold for $0.4 million and the costs of closure, including redundancy costs of excess labour, would be $1.7 million.
The following information relates to the production of the SMR-HDD moving to Indonesia. The project will require an initial investment of $2.3 million, to pay for the cost of land and buildings and machinery. This is tax allowable and will be fully depreciated on a straight line basis over the next four years. at the end of which it will have a negligible value.
Innotek will also need $0.4 million for working capital immediately. It is expected that the working capital requirement will increase at a rate of 10% per annum. When the project is sold, the working capital will not foam part of the sale price and will be released back to Innotek.
Production and sales of the device are expected to be 12.000 units in the first year. rising to 22.000 units. 47.000 units and 60.000 units in the next three years respectively.
The following revenues and costs apply to the first year of operation:
Each unit will be sold for $70.
The variable cost per unit comprising of locally sourced materials and labour will be $15.
Total fixed costs for the first year will be $0.3 million.
The costs are expected to increase by 5% per annum, but the selling price will remain fixed at $70 per unit for the four-year period.
The corporation tax rate in Indonesia is 20% and Innotek currently pays corporation tax at a rate of 17% per year. Both countries' corporation taxes are payable in the year that the tax liability arises.
Innotek's financing consists of 25 million shares currently trading at $2.40 each and $40 million, 6% bonds (coupon paid annually and matures in 5 years time) trading at $1,100 per $1.000. Its quoted beta is 1.4. The current risk free rate of return is estimated at 3% and the market risk premium is 6%.
(a) Compute Imiotek's weighted average cost of capital.
(b) Calculate the net present value if Innotek was to continue production of the SMR HDD locally.
(c) Calculate the net present value if Innotek was to move the production to Indonesia immediately.
(d) Analyse whether or not Innotek should undertake the project to produce SMR-HDD
in Indonesia and cease its local production immediately. Discuss other business factors that Innotek should consider before making a final decision.