Question

ASSIGNMENT 1 Burton is a small manufacturing company that makes furniture. They are considering a project where they will make special metal ornaments; this is considered to be in the normal area of its business. This will involve the company buying a new piece of equipment, the capital costs of which will be $400,000; there will also be an extra $50,000 of installation costs which can be expensed straight away. This piece of equipment will replace an old machine which has a book value of $50,000 and one year to go before it will have been depreciated to zero. The new equipment will be depreciated straight line to zero over five years with no salvage value at the end of its life. If the project is undertaken the old equipment will be sold for $90,000 The ornaments will retail for $12 each and will cost a total of $8 each to get to the market. In the final two years of the five-year project, it is expected that the costs will rise to $9 and $10 respectively. At the start of the project, it is expected that there will be $40,000 of stock required. At the same time accounts receivables will be $50,000 and accounts payable of $25,000. These levels will be maintained until the end of the project. The company expects to sell 80,000 units in the first year, rising to 100,000 in year 2 and 120,000 in year 3, before falling back to 100,000 for each of years 4 and 5. The company expects to incur an extra $50,000 in marketing costs in the first year, followed by $40,000 a year thereafter. The project will also incur $40,000 of overhead costs from the parent company. The survey cost of $30,000 will be paid in year 1 of the project. Two managers from the parent company will come and work on the project; their current salaries are $50,000 each and the parent company will have to hire two new managers to fill the vacated positions. The company expects to start two new managers at a salary of $40,000 each. The company is funded with $16 million of equity and $6 million of debt. The recent dividend growth rate at the company has been 6 %. The equity beta is 1.5 and the debt beta is 0.25. The company faces a tax rate of 30%. The risk free rate of interest is 4.6% and the stock market return is 10.6%. Required: (a) Calculate the cost of capital for the project (b) Lay out the cash flows for the project, with explanations as to why you have included and excluded certain cash flows. Calculate the NPV. Should the project be accepted? (c) Calculate the internal rate of return

Answer 1

a. Cost of capital for the project:

Before-tax Cost of debt=RFR+Debt Beta*Market risk premium)

ie.4.6%+(0.25*(10.6%-4.6%))=

6.10%

After-tax cost of debt=Before-tax cost*(1-Tax rate)

ie. 6.10%*(1-30%)=

4.27%

Cost of equity=RFR+(Equity Beta*Market Risk premium)

ie.4.6%+(1.5*(10.6%-4.6%))=

13.6%

Weighted av.Cost of capital=( Wt.d*kd)+(Wt. e*ke)

ie.(6/(16+6))*4.27%)+(16/(16+6))*13.6%)=

11.06%

Year	0	1	2	3	4	5
1.Capital cost+Installation	-400000
2.After-tax salvage of old equipment(90000-((90000-50000)*30%))	78000
3.NWC introduced & recovered(40000+50000-25000)	-65000					65000
4. CAPEX & NWC cash flows	-387000	0	0	0	0	65000
Operating cash flows
5.Selling price/unit		12	12	12	12	12
6.Cost/unit		8	8	8	9	10
7.Net revenue/unit(5-6)		4	4	4	3	2
8.No.of units to be sold		80000	100000	120000	100000	100000
9.Total net revenues(7*8)		320000	400000	480000	300000	200000
10.Marketing costs		-50000	-40000	-40000	-40000	-40000
11.Survey cost		-30000
12.Manager's salary(40000*2)		-80000	-80000	-80000	-80000	-80000
13.St.line depn.on new m/c(400000/5)		-80000	-80000	-80000	-80000	-80000
14.Before-tax income(sum9--13)		80000	200000	280000	100000	0
15.Tax at 30%(14*30%)		-24000	-60000	-84000	-30000	0
16.After-tax income(14-15)		56000	140000	196000	70000	0
17.Add Back: Depn.(Row 13)		80000	80000	80000	80000	80000
18.Annual Operating cash flow(16+17)		136000	220000	276000	150000	80000
19.After-tax Installation expenses(50000*(1-30%))	-35000
20.Depn. Tax shield lost on Old m/c(50000*30%)		-15000
21.Net annual cash flows(4+18+19+20)	-422000	121000	220000	276000	150000	145000
22. PV F at 11.06%(1/1.1106^Yr.n)	1	0.90041	0.81075	0.73001	0.65731	0.59185
23. PV at 11.06%(21*22)	-422000	108950.12	178364.06	201481.92	98596.29	85818.25
24. NPV(Sum of Row 23)	251210.63
1.Allocated overhead costs of parent company will be excluded , as they are not incremental in nature ,ie. The company will continue to incur them , irrespective of the project.
2. Because of the project, 2 new managers are going to be hired at $ 40000 each, making an incremental cash outflow of $ 80000 (before-tax) to the company.Hence they are included.
DECISION RULE: Project can be accepted as it gives POSITIVE NPV
c...25.IRR (Of Row 21)	32%