Question

QUESTION 2

2.1 As the director of a firm's capital budgeting department, you have been asked to evaluate a project. After collecting information from various sources, you have determined the following:

The firm's preference share pays a constant annual dividend of R2.25 and is currently selling for R20. The firm is expected to pay an ordinary share dividend of R3 in one year, with anticipated growth of 2% each year thereafter. Currently, the ordinary share is selling at a price of R23.75. The firm has 8-year bonds outstanding with a coupon rate of 8.75%, paid annually. The bonds are currently selling at par. The firm is currently being financed with R10 000 000 debt, R20 000 000 of ordinary equity, and R5 000 000 preference shares. The project requires the use of equipment valued at R6 200 000. The equipment currently has a book value of R3 000 000 with two years of straight-line depreciation (to zero) remaining (R1 500 000 each year). You anticipate that the equipment can be sold in three years for R2 100 000. Anticipated sales are 1 000 000 units per year based on a sale price of R11 per unit. The cost of producing each unit is R8.50. If the project is accepted, the firm will need to hire an additional manager with an annual salary of R80 000. Total research (information gathering for project analysis) expenses to date are R26 000. The firm's marginal tax rate is 40%.

2.1.1 Calculate the net present value of this project and the internal rate of return. Should the project be accepted? (25)

2.2 In the context of capital budgeting, what is an opportunity cost? Provide an example of an opportunity cost. (2)

2.3 ‘Since depreciation is a non-cash expense, we should ignore its effects when evaluating projects.’

Is this statement true? Please elaborate. (3)

Answer 1

2.1.1 Based on the data given we can come up with the Profit and Loss Statement for the Project for a 3 year period

Item	Year 1	Year 2	Year 3
Sales	$1,10,00,000.00	$1,10,00,000.00	$1,10,00,000.00
Cost of Goods Sold	$85,00,000.00	$85,00,000.00	$85,00,000.00
Depreciation Expenses	$15,00,000.00	$15,00,000.00
Salary Expense	$80,000.00	$80,000.00	$80,000.00
Research Expenses	$26,000.00
Selling Price of Equipment			$21,00,000.00
Operating Profit	$8,94,000.00	$9,20,000.00	$45,20,000.00
Tax Expenses (40%)	$3,57,600.00	$3,68,000.00	$18,08,000.00
Net Profit	$5,36,400.00	$5,52,000.00	$27,12,000.00

We can also get the Cash flows for the 3 years as follows:

Item	Year 0	Year 1	Year 2	Year 3
Operating Profit		$8,94,000.00	$9,20,000.00	$45,20,000.00
Depreciation Expenses		$15,00,000.00	$15,00,000.00	$0.00
Tax Expenses		$3,57,600.00	$3,68,000.00	$18,08,000.00
Initial Outlay	$62,00,000.00
Cash Flow	$62,00,000.00	$20,36,400.00	$20,52,000.00	$27,12,000.00

Based on the below data, we can calculate Weighted Average Cost of Capital

Rate of Preference Shares	11.250%
Rate of Equity Shares	14.632%
Rate of Debt	8.750%

Note that rate of preference shares can be calculated using the formula: Preference share dividend/ Market Price of share

Rate of Equity Shares can be calculated from: Share Price = Dividend Paid/ ( Rate of Equity - Growth Rate)

Preference Shares	$50,00,000.00
Equity Shares	$2,00,00,000.00
Debt	$1,00,00,000.00

Also,

which gives WACC = 11.468%

From the cash flows and WACC, we get NPV = -$763,499.77 and IRR = 4.54%

Hence the project should not be accepted.

2.2  Opportunity cost refers to the alternate mode of investment the company misses out on when choosing to invest in a particular project. Instead of investing on the initial capital expenditure required to start the project, the company could have invested the same amount in other financial products like stocks, bonds, mutual funds, fixed deposits etc.

2.3 Capital Budgeting takes into account incremental, after- tax cash flows which are made as a part of the project. Depreciation is a non-cash expense which is included in calculating the Taxes paid by the company as a part of the project. But it is added back while calculating the cash flows and hence its effect is nullified.