Capital Budgeting

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
$500,000, as a result of which it expects the new product to be successful. Hebac Co plans to
charge a lower selling price initially and then increase the selling price on the assumption that the
new product will establish itself in the new market. Forecast sales volumes, selling prices and
variable costs are as follows:
Year 1 2 3 4
Sales volume (units/year) 200,000 800,000 900,000 400,000
Selling price ($/unit) 15 18 22 22
Variable costs ($/unit) 9 9 9 9
Selling price and variable cost are given here in current price terms before taking account of
forecast selling price inflation of 4% per year and variable cost inflation of 5% per year.
Incremental fixed costs of $500,000 per year in current price terms would arise as a result of
producing the new product. Fixed cost inflation of 8% per year is expected.
The initial investment cost of production equipment for the new product will be $2·5 million, payable
at the start of the first year of operation. Production will cease at the end of four years because the
new product is expected to have become obsolete due to new technology.
The production equipment would have a scrap value at the end of four years of $125,000 in future
value terms.
Investment in working capital of $1·5 million will be required at the start of the first year of
operation. Working capital inflation of 6% per year is expected and working capital will be
recovered in full at the end of four years.
Hebac Co pays corporation tax of 20% per year, with the tax liability being settled in the year in
which it arises. The company can claim tax-allowable depreciation on a 25% reducing balance
basis on the initial investment cost, adjusted in the final year of operation for a balancing allowance
or charge. Hebac Co currently has a nominal after-tax weighted average cost of capital (WACC) of
12% and a real after-tax WACC of 8·5%.
The company uses its current WACC as the discount rate for all investment projects.
Required:
(b) Discuss how the capital asset pricing model can assist Hebac Co in making a better
investment decision with respect to its new product launch. (8 marks)
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.

Capital Budgeting

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Hebac Co is preparing to launch a new product in a new market which is outside its current

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