Question

You are considering an investment in nickel mines in Russia. Your expectations are that you will take losses eventually, but once infrastructure is built, the project will become more profitable very quickly. You have estimated that the initial revenues will be $100 million per year and grow at a rate of 45% per year for four years. Due to political risk, you decide to use only a four-year horizon for planning purposes. Variable costs are expected to be 70% of sales; fixed costs are projected to be $10 million per year.

Initial cost of machinery, land, equipment and other things amounts to $110 million. This $110 million will be depreciated straight-line to zero over a seven-year accounting life. However, the expected market value of the fixed assets at the end of four years is $50 million. Net working capital requirements are minimal, just $10 million at the beginning of the project, all of which will be recovered at termination. Tax rate of your company is 30%.

This project will be financed with both debt and equity. The plan is to mirror the firm’s target capital structure by issuing 15 million shares of stock priced at $10.00 a share and $170 million face value of 10-year bonds which will be priced at 94% of par if a coupon of 7% is offered to investors. The company will pay dividends of $3.60 per year (starting in one year) and increase the dividend by 4% per year indefinitely. Treasury bills offer 1% return and the expected market returns are 11% per year. The stock’s beta is 1.8. Assume flotation costs are 6% for debt and 18% for equity and are incurred only for the $100 million outlay for fixed assets. Create an Excel template where all the necessary calculations are made.

• What are the cash flows each year from this project?

• What is the W ACC?

• What is the total initial cost after adjusting for flotation costs?

• What are the NPV, IRR, PI and simple (not discounted) payback period for the project?

• WILL YOU ACCEPT THE PROJECT OR NOT? WHY (OR WHY NOT)

Answer 1

Depreciation calculations:

Dep per year = (110 - 0)/7 = 15.71

WACC calculation:

cost of equity: Ke

Ke = Rf + beta*(Rm - Rf)

Ke = 1% + 1.8(11% - 1%) = 19%

Cost of debt: yield to maturity

Settlement date	3/31/2020
Maturity date	3/30/2030
Coupon rate	7
Price	94
Redemption	100
Yield	7.4468085	=YIELD(B1,B2,B3,B4,B5,1)

Amount equity = 15million * $10 = $150m

Amount of debt = $170m

%equity = 150/(150+170) = 47%

% debt = 100 -47 = 53%

Tax rate = 30%

WACC = 0.47*19% + 0.53*7.44%*(1-30%) = 11.7%

Cash flows from project

Year	0	1	2	3	4
PPE	-110
Working capital	-10
Floating cost debt	-10.2
Floating cost equity	-27
Revenue		100	145	210.25	304.8625
Variable cost		-70	-101.5	-147.175	-213.404
Fixed cost		-10	-10	-10	-10
Dep		-15.7143	-15.7143	-15.7143	-15.7143
Interest (coupon)		-11.9	-11.9	-11.9	-11.9
Profit before tax		-7.61429	5.885714	25.46071	53.84446
Tax		0	1.765714	7.638214	16.15334
PAT		-7.61429	4.12	17.8225	37.69113
Dep+PAT		8.1	19.83429	33.53679	53.40541
Scrap PPE					50
Recovery WC					10
Cash flow	-157.2	8.1	19.83429	33.53679	113.4054
Initial cost	-157.2
Discount rate	11.70%
Discount factor	1	0.895255	0.801482	0.717531	0.642373
Present value	-157.2	7.251567	15.89682	24.06367	72.84858
NPV (sum)	-37.139363
IRR	3%
We will not invest in the project as NPV is negative & IRR is less than WACC