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Explain with a graph how SML is different from CML. Why CAPM equation might be more relevant than other equations when calculating required rate of return. (1000 words)
Berry Mount manufactures a variety of Pie. The company is considering introducing a new product (Pizza Pie). The company’s manager has been provided with the following information by their business analyst.
- The project has an anticipated economic life of 5 years.
- The Company plans to spend $1,250,000 on advertising campaign to boost sales.
- The Company’s interest expense each year will be $550,000.
- The Company is required to purchase a new machine to produce the new product. The machine’s initial cost is $6,500,000. The machine will be depreciated on a straight – line basis over 5 years. The Company anticipates that the machine will last for 10 years; the salvage value after 5 years is $600,000.
- Six months ago the Company also paid $400,000 to a firm to do research regarding new product.
- If the Company goes ahead with the new product, it will have an effect on the Company’s net operating capital. The forecasted net working capital will be $250,000 (at time zero)
- The new product is expected to generate sales revenue of $2,000,000, 2,500,000, 3,000,000 3,500,000 and 4,000,000 in year 1, 2, 3, 4 and 5 respectively. Each year the operating cost (not including depreciation) expected to equal 25 percent of sales revenue.
- In addition the Company expects with introduction of new product, sale of other Pie increase by $550,000 after taxes each year.
- The Company’s overall WACC is 8 percent. However, the proposed project is riskier than the average project; the new project’s WACC is estimated to be 10 percent.
- The Company’s tax rate is 30 percent.
- Find the net present value, internal rate of return, payback period, discounted payback period, and profitability index of the proposed project. Based on your analysis should the project be accepted? Discuss.
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