Question

Your company is looking at setting up a manufacturing plant overseas to manufacture driverless flying cars. The company bought some land in that that was just appraised for $3.8 million after tax. The proposed project will last five years. It is expected that you can sell the land at the end of 5 years for $4.1 million. The manufacturing plant will cost $34 million to build.

The following market data on your company are current. Debt: 195,000 bonds with a coupon rate of 6.2 percent outstanding, 25 years to maturity, selling for 106 percent of par; the bonds make semiannual payments.

Common Stock: 8,100,000 shares outstanding, selling for $63 per share; the beta is 1.1. 7 percent expected market risk premium and 3.1 percent risk free rate.

Your underwriter tells you the floatation costs for common stock, preferred stock, and debt are 7%, 5%, and 3% respectively. The corporate tax rate is 21%. The project requires $1.5 million in initial net working capital which will no longer be required at the end of the project.

a) This project is riskier than the typical project that your company normally undertakes. You have been told to adjust the risk factor by +2 percent. Calculate the appropriate discount rate to use when evaluating this project.

b) Calculate the average cost of floatation.

c) The manufacturing plant uses straight line depreciation to zero for the life of the project. At the end of the project (that is at the end of 5 years) the plant and equipment can be scrapped for $4.9 million. What is the after tax salvage value of this plant and equipment?

d) The company will incur $6.9 million in annual fixed costs. The plan is to manufacture 121 driverless flying cars per year and sell them for $1,145,000 each; the variable costs are $950,000 per unit. What is the annual operating cash flow (OCF) per year for the project?

e) What is the IRR and NPV of this project?

Answer 1

Input
Tax Rate (assumed)	30%	WACC	10%	VC	900000	Fixed Costs	6900000	Depreciation = (Cost - Salvage Value)/life	7000000
Selling Price		1145000		Units	121	Salvage Value	-1000000

a) Using Straight line Depreciation

The NPV is positive. This project should be accepted.

(Since the salvage value is negative, the tax shield on cost of disposal will add to cash inflow, whereas the cost of disposal itself will be a cash outflow.

b) Using MACRS depreciation

The NPV of the project is positive, therefore it should be accepted.