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 TL in the first year, 4 million TL in the second year, 4 million TL in third year, 3 million TL 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?

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

Given, Debt / Equity =0.5

Debt = 0.5*Equity

Total capital = debt + equity

=0.5Equity + equity

Total capital =1.5 Equity

Weight of debt = W_d= 0.5 Equity / 1.5 equity =0.5/1.5=0.333333

Weight of Equity= W_e=1/1.5=0.6666666

Cost of Debt =K_d=14%(1-tax rate)

=14%(1-0.2)

K_d=11.20%

Given, Market risk premium =8%

i.e., R_m-R_f=8%

yield of government bonds=R_f=12%

Beta=1

As per CAPM model,

Cost of Equity(K_e)=R_f+Beta(R_m-R_f)

  Cost of Equity(K_e)= 12%+1(8%)

Cost of Equity(K_e)=20%

Computation of Weighted AVERAGE COST OF CAPITAL(WACC):

WACC=    K_d * W_d+ K_e*W_e

= 0.333*11.20%+0.66667*20%

WACC =17%

present value of Cash flows:

={Cash flow / (1+i) }ⁿ

where i=17% and n = Number of cash flows

Annual depreciation=(22millions-2millions)/5 uears

=$4,000,000

Salvage value before tax= $4,000,000

Gain on salvage tax= 4millions-2millions= $2,000,000

Tax on gain @20%=   $2,000,000*20% = $400,000

After-tax salvage value = $4,000,000-$400,000

=$3,600,000

Since the NPV is Positive and IRR higher than WACC, the project is feasible.