Reference no: EM132399277

Kindleberger's is a high tech. engineering company. As part of its product development program it has come up with a product that is not in its usual market-place, which is as an auto parts supplier. The new product is a robot lawnmower, which is voice controlled. The product development department believe there will be a market for 40 000 of these in the first year, growing to 60000 in year two, followed by 80 000 for the next two years, and 70 000 in the fifth year. They believe that this is a conservative forecast. The units will cost £20 each to produce and will retail for £45 each in the first three years and for £40 each in the last two years. Manufacture of the mowers will take place on an unused production line in their main factory. The production line could not be used for anything else in the first year, but the firm was going to use it for car seat production from year 2. This will involve building an extension to the factory three years earlier than expected. The new extension will be built in year 1 at a cost of £2m instead of year 4 for £2m. The equipment being used is existing machinery, which was going to be sold off. The company had received an offer of £700000 for the machinery, which had originally cost £3 million seven years ago. The machinery is being depreciated straight line to zero over ten years. The new product will need a marketing campaign which will cost £350000 and £300000 in years 1 and 2, then £200000 in each of the remaining years. Increased distribution costs will run at £150000 per year. Initial working capital for the project is expected to be £250000, with further increases of £150 000 and £100 000 in years one and two. Working capital will remain at these levels until the winding down of the project in year 5. Expected maintenance costs for the production line will be £75 000 in years 2 and 4. This parent company has a cost of equity of 11%, a pre-tax debt rate of 7%, and a capital structure with 30% debt in it. The company faces a tax rate of 30%. This project has a different risk profile to the parent company. There is a company that is doing similar activities; it has only 10% debt in its capital structure, with a pre-tax cost of 8%. It has an equity beta of 1.4; the risk free rate is 5%, and the equity risk premium is 6.5%. Kindleberger thinks the mower project should be 90% equity funded. Required:a.Lay out the cash flows for the project. (8 marks)b.Calculate the cost of capital for the project and calculate the NPV of the project. Should the company go ahead with the project or just sell the equipment? (6 marks)c.The company has another project where the NPV is negative £50000, but where the managers are arguing that there is a real option involved where there is the option to end the investment after 5 years. This would require an investment of £700000 at £650000 at the end year 5. The project would be of the same risk as the one in the part (a), the application risk free rate is the same and the volatility of the cash flows is 35%. Tjis investment would extend the life of the project by another 5 years. What is the value of this real option? What impact would this have on the decision regarding the original project?