A firm which is financed 60% by equity and 40% by debt is considering the introduction of a new product which will have a life of 5 years. Recent findings have shown an average return to equity of 15% which is 1.5% higher than the cost to equity and a return to debt before tax of 10% which is similar to cost of debt. Tax rate is 20% universal.
Two alternatives of promoting the product have been identified:
Alternative One:
This will involve employing a number of agents. An immediate expenditure of Rs4M will be required to advertise the product. This will produce net annual cash inflows of Rs200,000 at the end of each of the five subsequent years. However the agents are to be paid Rs40,000 each year. On termination of the contract, the agents will have to be paid a lump sum of Rs80,000 at the end of the fifth year.
Alternative Two:
Under this alternative, the firm will not employ agents but will sell directly to the customers. The initial expenditure on advertising will be Rs220,000. This will bring in cash of Rs 130,000 at the end of each year. However this alternative will involve out-of-pocket sales administration to the extents of Rs35,000. The firm also proposes to allocate fixed costs worth Rs22,000 per year to this product if this alternative is pursued.
Required:
Advise the management as to the method of promotion to be adopted. You may assume a weighted average cost of capital in your analysis.