Question

A firm producing digital cameras considers a new investment which is about opening a new plant.

The project’s lifetime is estimated as 5 years and requires 22 million TL as investment cost. Salvage value of the project is estimated as 4 million TL (which will be received in the sixth year) However firm prefers to show salvage value only as 2 million TL. Firm uses 5-year straight line depreciation.

It is estimated that the sales will be 12 million TL next year and then sales will grow by 20% each year.

It is estimated that fixed costs will be 1.5 million next year and then will grow by 5% each year.

Variable costs are projected %10 of sales each year.

This project, in addition, requires a working capital of $ 3 million in the first year, 4 million in the second year, 4 million in third year, 3 million in the fourth year and 1.5 million in the fifth year.

Firm plans to use a debt/equity ratio of %50 in this project.

The company can borrow TL loan with an interest cost of 14% before tax. Corporate tax rate is 20%. The shares of this company in Borsa Istanbul are selling at 8 TL and the stocks have approximately market risk and have strong correlation with BIST100 index. 10- year government bond yields at %12 and market risk premium is %8.

Given this information; find the NPV and IRR of the project; is this project feasible or not?

If you want, you can solve this question using excel.

What is the result of higher WACC ? Can a company reduce its WACC ? If yes, how? Give numerical example related with this project and explain this topic briefly regarding to the capital structure theories.

Answer 1

CALCULATION OF WEIGHTED AVERAGE COST OF CAPITAL:

Source of Fund	Cost of Fund (After Tax)	Weight	Weighted Cost of Fund
Debt	11.2%	50%	5.6%
Equity	20%	50%	10%
			15.6%

Therefore, the Weighted Average Cost of Capital is 15.6%.

Note:

1. Calculation of Cost of Debt after Tax

2. Calculation of Cost of Equity

The Return on 10- year government bond yields at 12% is taken as Risk Free Rate of Return.

Since, shares of Borsa Istanbul have market risk having strong correlation with BIST100 Index therefore the beta of Stock is 1.

CALCULATION OF NET PRESENT VALUE (NPV) OF THE PROJECT:

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
	TL	TL	TL	TL	TL	TL	TL
Initial Investment	(22,000,000)	-	-	-	-	-	-
Sales	-	12,000,000	14,400,000	17,280,000	20,736,000	24,883,200	-
Less; Variable Costs	-	(1,200,000)	(1,440,000)	(1,728,000)	(2,073,600)	(2,488,320)	-
Less: Fixed Costs	-	(1,500,000)	(1,575,000)	(1,653,750)	(1,736,438)	(1,823,259)	-
Less: Interest on Loan	-	(1,540,000)	(1,540,000)	(1,540,000)	(1,540,000)	(1,540,000)	-
Less: Depreciation	-	(4,000,000)	(4,000,000)	(4,000,000)	(4,000,000)	(4,000,000)	-
Net Income before Tax	-	3,760,000	5,845,000	8,358,250	11,385,963	15,031,621	-
Less: Tax	-	(752,000)	(1,169,000)	(1,671,650)	(2,277,193)	(3,006,324)	-
Net Income after Tax	-	3,008,000	4,676,000	6,686,600	9,108,770	12,025,297	-
Add: Depreciation	-	4,000,000	4,000,000	4,000,000	4,000,000	4,000,000	-
Net Cash Income After Tax		7,008,000	8,676,000	10,686,600	13,108,770	16,025,297
Working Capital Investment	-	(3,000,000)	(4,000,000)	(4,000,000)	(3,000,000)	(1,500,000)	-
Receipt from Salvage Value							4,000,000
Receipt from Recovery of Working Capital							15,500,000
Net Cash Inflow/(Outflow)	-	4,008,000	4,676,000	6,686,600	10,108,770	14,525,297	19,500,000
Present Value Factor @ 15.60%	1	0.8651	0.7483	0.6473	0.5600	0.4844	0.4190
Present Value of Cash Inflow/(Outflow)	(22,000,000)	3,467,128	3,499,120	4,328,444	5,660,659	7,036,162	8,171,233

NET PRESENT VALUE OF THE PROJECT:

PRESENT VALUE OF CASH INFLOW - PRESENT VALUE OF CASH OUTFLOW

TL 32,162,747 - TL 22,000,000

TL 10,162,747

CALCULATION OF IRR OF THE PROJECT:

IRR refers to rate of return at which Present Value of cash Inflow equals Present Value of Cash Outflow.

Present Value of cash Inflow @ 30%
3,083,076.92
2,766,863.91
3,043,513.88
3,539,361.37
3,912,084.66
4,039,936.12
20,384,836.85

Using Interpolation: