Question

Question 3
The salesman from SuperFast Machines claims that if you trade-in your old machine for one of his new machines, you could save your company $60,000 a year. As his new machine costs $120,000 after the trade-in, the investment pays for itself in 2 years. Since the machine has a life of 3 years and a salvage value of $30,000, the salesman claims that this deal lets you use the machine for free in year 3 as well as receiving a $30,000 when the machine is sold. Having learnt about capital budgeting techniques, you are quite skeptical of his claims. Use the data below to do your own sums.

• Cost of new machine $120,000
• Salvage value of machine at end of life $30,000
• Useful life 3 years
• Operating cost savings $60,000
(excluding depreciation) from new machine
• Depreciation policy Depreciate to zero
You have also obtained the following financial information regarding the company and the market.

Shares
• Issued 2,000,000 shares.
• Current share price = $10
• Company just paid a dividend of $1.20 per share. Dividends are expected to be maintained at this level for the foreseeable future.
• Beta of shares = 1.0

Bonds
• Issued 20,000, 5% coupon bonds with par value of $1,000 with remaining maturity of 10 years.
• Bonds are currently selling at the par value.

Market
• 10-year Treasury bond yield = 4%
• 10-year AAA bond yield = 4.5%
• 10-year AA bond yield = 5%
• Expected return of the stock market = 12%
• Corporate tax rate = 20%
(a) Compute the cost of equity, cost of debt and the weighted average cost of capital.

(b) Explain which capital budgeting method the salesman is using when he claims that the machine pays for itself in 2 years.

(c) Calculate the operating cash flows related to this project.

(d) Calculate the cash flows from assets for the project.

(e) Determine whether the machine should be bought.

(f) Discuss two (2) advantages of using the NPV versus the payback period.

Answer 1

a]	Cost of equity per CAPM = risk free rate+beta*(expected market return-risk free rate) = 4%+1*(12%-4%) =	12.00%
	After tax cost of debt = 5%*(1-20%) =	4.00%
	WACC:
	Component	Market Value	Weight	Component Cost	WACC
	Equity [2000000*$10]	$     2,00,00,000	50.00%	12.00%	6.00%
	Debt [20000*$1000]	$     2,00,00,000	50.00%	4.00%	2.00%
	Total	$     4,00,00,000			8.00%
	WACC = 8.00%
b]	The salesman is using the payback period. The payback
	period is the number of years by which time the cash inflows
	from the project will recoup the initial investment.
c]	Operating cost savings	$              60,000
	Depreciation [120000/3]	$              40,000
	Incremental NOI	$              20,000
	Tax at 20%	$                 4,000
	Incremental NOPAT	$              16,000
	Add: Depreciation	$              40,000
	Operating cash flows related to the project	$              56,000
d]		0	1	2	3
	Operating cash flow		$       56,000	$         56,000	$      56,000
	Capital expenditure	$           1,20,000
	After tax salvage value = 30000*(1-20%) =				$      24,000
	Cash flow from assets	$         -1,20,000	$       56,000	$         56,000	$      80,000
e]	PVIF at 8%	1	0.92593	0.85734	0.79383
	PV at 8%	$         -1,20,000	$       51,852	$         48,011	$      63,507
	NPV	$              43,369
	As the NPV is positive, the machine should be bought.
f]	The 2 advantages of NPV over payback are:
	*NPV takes into account the time value of money
	*NPV considers the entire cash flows of a project.