The ABC company sells regular watches (pre-tax EBIT margin is 20% of sales, expected to remain unchanged in the future) priced at $35 each. It sold 10000 pieces this year, and both the price and sales quantity are expected to grow at the rate of inflation. It is proposing to introduce a new line of luxury watches.
New project details:
It is expected that luxury watch sales will be 50000 pieces in the first year, and rise at a constant percentage rate to 100000 in year 5, and then drop at a constant percentage rate to 60000 by year 10. Fixed operating costs are expected to be $2 million per year. Variable costs will be 75% of sales in year 1, and then reduce by 3% every year to 48% in year 10. The initial sales price will be $500 per watch in year 1, and then will rise at the rate of (inflation + 1%) thereafter. Because it introduces the new luxury watches, it will reduce its sales of regular watches by 75%. It will have to use land it already has, with a market value of $2 million. The buildings and machinery will cost $1 million at the start of each of the next two years, and working capital will be 10% of total sales, invested at the start of each year. The fixed assets will be depreciated to zero over 5 years, zero salvage value. Land will increase in value with inflation, and working capital will retain its value.
Inflation is expected to be 2% in year 1, increase to 3% in years 2 through 7 and then remain at 3.5%. The tax rate is 35%, equity beta is 1.2, Rf is 5% and MRP is 7.5%. Over the next 10 years, ROE is expected to be 12%, ROA is expected to be 8%. Debt constitutes 25% of the firm’s capital structure in market value terms. ABC has current debt (15 year bonds issued on March 2007), paying $3.5 semi-annual coupon trading at $101.25. Compute the NPV of the transaction.