Question

The company  is deciding on which equipment to acquire. Each is worth 20Million. The company thinking if financing the 50% equity, 25 % via 5 year term loan at 7.5 % annual effective interest and the balance via $100/ share callable preferred shares of stock that promises to pay 4% quarterly dividends. The company consistently paid the 5% semi annual dividends on its common shares. Calculate the weighted average cost of capital of the project. Disregard taxes in your computations. Assume full principal payment on year 5.

After receiving proposals from suppliers, the finance manager came up with the following comparative cash flow projection:

                        Equipment A                           Equipment B

Year 1              $2,000,000                              $4,000,000

Year 2              $2,000,000                              $4,000,000

Year 3              $5,000,000                              $4,000,000

Year 4              $5,000,000                              $4,000,000

Year 5              $6,000,000                              $4,000,000

Using the information derived above, and using the Net Present Value (NPV), Discounted Payback Period and Profitability Index, which will you recommend of the two equipment to acquire?

Answer 1

Calculation of Weighted Average Cost of capital:

Source	Weight	Cost of Capital	Weighted Cost of capital
Equity	0.5	10.2500%	5.1250%
Loan	0.25	7.5000%	1.8750%
Prefrence Shares	0.25	16.9859%	4.2465%
WACC			11.2465% or 11.25%

Note:Cost of Equity=1.05^{^2}-1

=.1025 or 10.25%

Cost of Prefrence Share=1.04^{^4}-1

=.169859 or16.9859%

Calculation of Present Value of Cash Inflows:

Year	Cash Flow 1	Cash flow2	PV Factor	Discounted CF1	Discounted CF2
1	2000000	4000000	0.898876	1797752.809	3595505.618
2	2000000	4000000	0.807979	1615957.581	3231915.162
3	5000000	4000000	0.726273	3631365.351	2905092.281
4	5000000	4000000	0.65283	3264148.63	2611318.904
5	6000000	4000000	0.586813	3520879.421	2347252.947
Present Value of Cash Inflows				13830103.79	14691084.91

Calculation of Net Present Value:

Present Value of Cash Inflows				13830103.79	14691084.91
(-)Investment				20000000	20000000
NPV				-6169896.208	-5308915.088

As the NPV is negative, none of the project is acceptable.

Calculatin of Discounted Payback Period:

if the npv is negative it means the cost of project is not being recovered in the lifetime of the project. hence discounted payback period of both the projects shall be more than 5 years.

Profitability Index of the projects:

Profitability index=total of discounted cash inflows/Investment

Present Value of Cash Inflows				13830103.79	14691084.91
Investment				20000000	20000000
Profitability Index				0.69150519	0.734554246

Recomendation: Based on the NPV(i.e.negative),Discounted Payback Period(i.e. more than life of projects) and Profitability Index(i.e.Less than one) it is recomonded not to accept any of the above projects.