Hebac Co is preparing to launch a new product in a new market which is outside its current business operations. The company has undertaken market research and test marketing at a cost of $500,000, as a result of which it expects the new product to be successful. Hebac Co plans to charge a lower selling price initially and then increase the selling price on the assumption that the new product will establish itself in the new market. Forecast sales volumes, selling prices and variable costs are as follows:
Calculate the net present value of the investment project in nominal terms and comment on its financial acceptability.
The NPV is strongly positive and so the project is financially acceptable.
Workings
Sales revenue
Alternative calculation of after-tax cash flow
Discuss how the capital asset pricing model can assist Hebac Co in making a better investment decision with respect to its new product launch.
A company can use its weighted average cost of capital (WACC) as the discount rate in appraising an investment project as long as the project’s business risk and financial risk are similar to the business and financial risk of existing business operations. Where the business risk of the investment project differs significantly from the business risk of existing business operations, a project-specific discount rate is needed.
The capital asset pricing model (CAPM) can provide a project-specific discount rate. The equity beta of a company whose business operations are similar to those of the investment project (a proxy company) will reflect the systematic business risk of the project. If the proxy company is geared, the proxy equity beta will additionally reflect the systematic financial risk of the proxy company.
The proxy equity beta is ungeared to remove the effect of the proxy company’s systematic financial risk to give an asset beta which solely reflects the business risk of the investment project.
This asset beta is regeared to give an equity beta which reflects the systematic financial risk of the investing company.
The regeared equity beta can then be inserted into the CAPM formula to provide a project-specific cost of equity. If this cost of capital is used as the discount rate for the investment project, it will indicate the minimum return required to compensate shareholders for the systematic risk of the project. The project-specific cost of equity can also be included in a project-specific WACC. Using the project-specific WACC in appraising an investment project will lead to a better investment decision than using the current WACC as the discount rate, as the current WACC does not reflect the risk of the investment project.