FIN4801 1 Capital budgeting. Brooks Ltd manufactures and sells pants and recently the company decided to expand into the shirt manufacturing industry as well. The owners of the company believe that the shirt industry is less volatile compared to pants and it is necessary to diversify some risk away by doing so. The management of the company has not taken this new strategic direction lightly and wants you to look into it for them. They feel that while the shirt industry is less risky and it is generally a good idea, more concrete analysis is required. To start, they will first undertake a pilot project: Project Shirt, which will manufacture a few different shirts and test the market over a period of four years. You find some old spreadsheets from your predecessor who estimated the risk inherent in previous projects undertaken in the pants industry as well as useful information such as the company’s cost of capital. The company as a WACC of 16%, which is the same as its cost of equity by which way it is 100% financed, inflation is 5% and the company uses the real rate of return to evaluate projects. Depreciation is conducted on a straight line, basis, always over the 4 year life of the asset. In compiling your report, you locate the following information: The shirt industry beta is 0,5 and after the project is implemented, it is expected that it will make up 20% of Brooks’ assets. The risk free rate of return is 8% and the market risk premium 6%. The applicable tax rate is 28%, the project is non-renewable and non-divisible. Project Shirt will initially cost R800 000 require an increase in working capital of R200 000 for cloths and such and all the machinery can be sold for R100 000 at the end of the project period. The project is expected the generate sales of R500 000 per year. Variable costs are expected to be 40% of sales and fixed costs are expected to be only R30 000 per year. Evaluate the viability of the project taking inflation and project risk into account and give a brief but detailed report to management.