Investment Appraisal: Fitness Guru plc

Description of the assignment:
Fitness Guru Plc is a research company specialising in the research and development of fitness gadgets. The company has already spent £3 million on R&D on a pet life style monitoring kit in the past few years. As a company director, you now face two mutually exclusive options (as follows) to exploit the financial potential of the new product. Ignore taxation and inflation.
Option 1:
Fitness Guru Plc could manufacture the pet life style monitoring kit itself. Manufacturing equipment will cost £40 million. The equipment would be bought on the last day of the company’s current financial year. £12 million in working capital is needed before the production can begin. The estimated scrap value of the equipment at the end of the production period is £5million. Fitness Guru Plc has a large warehouse which can be used as a factory for manufacturing the pet life style monitoring kit. The warehouse is currently leased to another company for £800,000 a year.
Fitness Guru Plc can sell the new product at £130 per unit in the first two years followed by a decline to £90 per unit for the remaining years. Variable cost are estimated to be £70 per unit. Marketing expenses including online advertising will be £12 million a year. Fixed costs will be £14.5 million a year including depreciation.
Fitness Guru Plc estimates the future sales from next year onwards as follows (assuming a product life of 5 years due to potential advances in technology):
Year 1 Year 2 Year 3 Year 4 Year 5
Number of units (000s) 500 1,200 1,500 2,000 600
Fitness Guru Plc plans to use the straight-line depreciation method on manufacturing equipment. The directors set a target accounting rate of return on investment of 15 per cent and a payback period of three years for all projects. The company currently uses a cost of capital of 10 per cent per year for all investments, but is considering using a cost of capital which reflects the capital structure of the company (the Weighted Average Cost of Capital).
The company’s current capital structure is:
Balance Sheet extract as at 31st December 2017
Long-term Debt
7% Bonds 120
Issued Share capital
Ordinary shares (50p) 250
Additional Information:
The ordinary shares for Fitness Guru plc are currently trading at £0.9 and the market price of the bonds is £125
The return on Government bonds is currently 1.5%, the return on the market portfolio has been estimated at 7% and the company’s beta has been estimated as 1.3.

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