Reference no: EM13153307

Bobs Bikes Ltd has recently (late 2003) completed a $100,000, two-year marketing study on introducing a new tricycle model. Based on the results of the study, Bobs Bikes expects to sell 1,000 of the new tricycles in 2004 at a price of $300 each. Sales volume will grow at 10% p.a. for the four years through to 2007 in real terms and Bobs expects that the price for each tricycle will increase along with the expected inflation rate of 5% p.a.

Bobs will need to buy a tricycle welding machine for $500,000. The machine will be depreciated for tax purposes over five years using straight line depreciation. The incremental labour expenses to produce the tricycles will be $100,000 p.a. without allowing for inflation. Materials are expected to cost $100 per tricycle in 2004 dollars Labour and materials prices will grow with inflation. Bobs Bikes also expects that the company will need $100,000 in working capital to run the business; this amount is not expected to grow.

Bobs Bikes is an ongoing, profitable business and pays taxes at a 30% rate on all income. Bobs Bikes has a 50% target debt/equity ratio, a nominal cost of equity of 14% p.a. and a nominal cost of debt of 8% p.a. 

At the end of 2007 Bobs Bikes plans to consider the following alternatives:

(a) Sell the welding machine for $200,000 and close the tricycle business; or
(b) Sell the tricycle business for an after-tax price of five times the 2007 after-tax profit