Question 3 – Capital Investment Analysis (10 marks)
The following discussion presents hypothetical information relating to a new proposal designed to improve the profitability of Just Jeans. The management team of Just Jeans have just received a new proposal from one of the firm’s marketing managers. The proposal outlines a new investment to create a Custom Finish Lab. Through the lab, online customers will be able to select an option to personalise their jeans in a range of finishes including blast wash, scrape wash, faded wash, and ripped and scuffed.
It will cost $1,650,000 to establish the lab. This cost will be depreciated on the straight-line basis over the 7 year life of the lab.
Customers will be charged $35.00 to use the custom service. In the first year of the lab’s opening, 35,000 customers are expected to use the custom service. It is expected that usage rates of the service will increase by 10% p.a. over the life of the lab (the price will not change and will remain at $35.00 per customer over the life of the lab). The custom lab is expected to increase jean sales by $550,000 in the first year of operation. This will increase by 12% p.a. over the life of the lab. On average, cost of sales for these jean sales is expected to be 60% for every sales dollar.
The cost to run the lab will include staff costs ($900,000 p.a.), materials costs ($210,000 p.a.), marketing costs ($46,000 p.a.), and other costs ($25,000 p.a.). These costs will increase by 6% p.a. over the life of the project.
The firm’s tax rate is 30%. The firm has a required rate of return of 16% on all investments.
- In relation to the above proposal, calculate the:Annual after tax cash flows and annual after tax profit.
- Payback period.
- Net present value and internal rate of return.
- Accounting rate of return (4 Marks).
- Provide an overview of the key environmental and social factors that Just Jeans should consider in evaluating the proposal (3 Marks).
- Based on an assessment of financial considerations and other factors, provide a recommendation as to whether Just Jeans should go ahead with the proposal. How sensitive are your recommendations to changes in projections of the financial impact of the new capital investment? (3 Marks)
Ensure that your answers for the above are discussed and supported by relevant calculations/workings.