Capital Budgeting Analysis for SunTech Ltd's Project Proposals

SunTech Ltd (STE) manufactures cutting-edge lithium-ion batteries to be incorporated into electric boats. The board has very recently recognised that a move to more environmentally responsible stance throughout company operations is required to maintain its competitive performance in the future as consumer and investor values shift. Historical share price, dividends and relevant index data for year ended 30 June are shown in the table below.

Currently, the yield to maturity on relevant government bonds is 4.35% and STE’s beta (based on more detailed and appropriate data than in the table above) is 1.64. The long-term average market risk premium is 6.5%.

The company’s project evaluation policy

The company’s project evaluation policy dictates that all proposals use a cost of capital proxied by the expected return on the company’s shares, estimated using CAPM. Project approvals below Board level are subject to an internally (not externally) imposed annual capital spending limit of $30 million.

The projects

The company has two project proposals this year (Project A and Project B), each with risk similar to the overall company.

Project A

Project A has a five-year life and involves expansion of a current product line of high-tech lithium-ion batteries class A. Net cash flows for Project A have already been estimated (see table below). You have checked the detail behind these cash flows and found the estimates to be sound.

Project B

Project B involves an expansion of a current product line of high-tech recycled lithium-ion batteries class B with a new range made from recycled household batteries. Cash flow estimation is not yet complete.

STE forecasts that the new range will be made available for only 5 years. So far, the company has spent

$450,000 on background product research on the product and this research forms the basis of the following estimates.

First year sales are forecast to be 15,500 units and this is predicted to increase by 25% in each of the second and third years. However, demand is expected to fall after that, leading toa decrease by 20% in each of the final two years. First year selling price will be set at $2,300 per unit and will be increased each year by 7%. It is expected that Project B will bring in more and different customers and slightly increase sales of the company’s other products. 

The cost of goods sold for the recycled lithium-ion batteries range is anticipated to be 65% of sales revenue. Additional administrative costs (excluding depreciation) of $1.5 million are projected in year one and will rise each year after that in line with inflation forecasts averaging of 5% per annum. The marketing department plans to run an intensive advertising campaign for the recycled lithium-ion batteries range in its first year at a cost of $3 million and, from year two, advertising costs related to this range will be $600,000 per year.

Additional equipment costing $18 million will be needed upfront for Project B. Depreciation on the equipment will be based on the prime cost method at a rate of 15% per year. At the end of the project life, the equipment will be sold for a projected $8 million. The project’s net working capital needs will begin upfront and will be 20% of the next year’s forecast sales revenue.

A 30% tax rate applies to the company’s profits.

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