Question

An investment project’s lifetime is estimated as 6 years and requires 30 million TL as investment cost. Salvage value of the project is estimated as 8 million TL (which will be received in the 7th year) However firm prefers to show salvage value only as 3 million TL. Firm uses 6-year straight line depreciation.

It is estimated that the sales will be 14 million TL next year and then sales will grow by 15% each year.

It is estimated that fixed costs will be 3 million next year and then will grow by 10% each year.

Variable costs are projected %25 of sales each year.

This project, in addition, requires a working capital of 3 million TL in the first year, 4 million in the second year, 5 million in third year, 6 million in the fourth year and 4 million in the fifth year and 3 million in the sixth year.

Firm plans to use a debt/equity ratio of %60 in this project. Corporate tax rate is %20.

Estimate a logical WACC in TL for this company. You should give logical numbers while estimating cost of debt and cost of equity considering current risk-free rates and market risk premiums in Turkey. This company has higher systematic risk compared to market.

Show step by step how you calculate cost of debt and cost of equity. Give logical numbers and write the reasons.

Calculate NPV and MIRR of this project? If this a feasible project?

Answer 1

Project Lifetime = 6 years

Investment Cost = 30 million TL

Salvage Value of Project = 8 million TL (received in 7^th year),

Firm shows 3 million TL as Salvage value, uses 6 year straight line depreciation.

Depreciation = ( Initial Value – Salvage Value ) / Lifetime

Depreciation = ( 30 million – 3 million ) / 6 years

Depreciation = 4.5 million TL per annum

Sales = 14 million TL, 15% annual growth

Fixed costs = 3 million TL, 10% annual growth

Variable costs = 25% of sales

(million TL)	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Sales	14	16.10	18.52	21.29	24.49	28.16
Fixed Costs	3	3.09	3.18	3.28	3.38	3.48
Variable Costs	3.50	4.03	4.63	5.32	6.12	7.04
Profits	7.50	8.99	10.70	12.69	14.99	17.64

WC

Year 1 = 3 million

Year 2 = 4 million

Year 3 = 5 million

Year 4 = 6 million

Year 5 = 4 million

Year 6 = 3 million

Free Cash Flow = Net Income + Non Cash Expenses – Capital Expenditure – Change in Working Capital

(million TL)	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
Net Income	7.50	8.99	10.70	12.69	14.99	17.64
Non Cash Expenses	4.5	4.5	4.5	4.5	4.5	4.5
Capital Expenditure	0	0	0	0	0	0
Change in Working Capital	3	1	1	1	-2	-1	3
Salvage Value							3
FCF =	9.00	12.49	14.20	16.19	21.49	23.14	6

                         

Debt equity ratio = 60%

Corporate Tax = 20%

Capital Requirement

Initial Investment = 30 million

Therefore, considering debt equity ratio of 60%,

Debt = 11.25 million TL

Equity = 18.75 million TL

Calculation of WACC via CAPM

Turkey risk free rate = 12.2%

Turkey market risk premium = 6.2%

Data source: http://www.market-risk-premia.com/tr.html

Cost of Debt = interest rate x (1-tax rate)

Cost of Debt = 0.122 x (1-0.2)

Cost of Debt = 0.0976 or 9.76%

We consider beta to be higher than 1 (~ 1.1) as the question mentions this company has higher systematic risk than the market.

Cost of Equity (CAPM) = risk free rate + beta x (market risk premium)

Cost of Equity (CAPM) = 0.122 + 1.1 x (0.062)

Cost of Equity (CAPM) = 0.1902 or 19.02%

WACC = { cost of equity x (% of equity) } + { cost of debt x (% of debt)}

WACC = { 0.1902 x 0.625 } + { 0.0976 x 0.375 }

WACC = 0.155475 or 15.5475 %

Calculating NPV

All amounts in million TL

Year	Amount (FCF)
0	-30
1	9
2	12.49
3	14.2
4	16.19
5	21.49
6	23.14
7	6

Cost of Capital = 15.55%

Net Present Value (NPV) = PV of all years - initial investment

Present Value (PV) = Amount / (1+r) ^ n

PV year 1 = 9 / (1 + 0.1555) ^ 1 = 7.79

PV year 2 = 12.49 / (1 + 0.1555) ^ 2 = 9.35

PV year 3 = 14.2 / (1 + 0.1555) ^ 3 = 9.20

PV year 4 = 16.19 / (1 + 0.1555) ^ 4 = 9.08

PV year 5 = 21.49 / (1 + 0.1555) ^ 5 = 10.43

PV year 6 = 23.14 / (1 + 0.1555) ^ 6 = 9.72

PV year 7 = 6 / (1 + 0.1555) ^ 7 = 2.18

Sum of PV = 7.79 + 9.35 + 9.20 + 9.08 + 10.43 + 9.72 + 2.18

Sum of PV = 57.75 million

NPV = Sum of PV – initial investment

Therefore NPV = 57.75 - 30 = 27.75 million TL

Since the NPV is positive, the project is feasible.