Question

QUESTION 2: WEIGHTED AVERAGE COST OF CAPITAL
2.1. Galaxy Industries Limited is a large publicly listed company and is the market leader in vacuum cleaner manufacturing in New Zealand. The company is looking to set up a manufacturing plant overseas to produce a new line of commercial vacuum cleaners. This will be a six-year project. The company bought a piece of land four years ago for $ 8 million in anticipation of using it for its proposed manufacturing plant. If the company sold the land today, it would receive $ 9.75 million after taxes. In six years the land can be sold for $14 million after taxes and reclamation costs. Galaxy Industries Ltd wants to build a new manufacturing plant on this land. The plant will cost $275 million to build. The following market data on Galaxy Industries Ltd are current:
Debt
$120,000,000,7.25% coupon bonds outstanding with 20 years to maturity redeemable at par, selling for 95 percent of par; the bonds have a $1000 par value each and make semi-annual coupon payments.
Equity
15,000,000ordinary shares, selling for $55 per share
Non-redeemable Preference shares
12,000,000 shares (par value $ 10 per share) with 6.5% dividends (after taxes), selling for $32 per share
The following information is relevant:
• Galaxy Industries Ltd’s tax rate is 28%
• The company had been paying dividends on its ordinary shares consistently. Dividends paid during the past five years is as follows
Year (-4) ($)
Year (-3) ($)
Year (-2) ($)
Year (-1) ($)
Year (0) ($)
4.6
4.8
5.3
5.5
6.0
• The project requires $ 7.95 million in initial net working capital investment in year 0 to become operational.
Required:
1. Calculate the project’s initial, (time 0) cash flows.
2. Compute the weighted average cost of capital (WACC) of Galaxy Industries Ltd. Show all workings and state clearly any assumptions underlying your computations.

3. Using the WACC computed in part (2) above and assuming the following, compute the project’s Net Present Value (NPV), Internal Rate of Return (IRR) and the Profitability Index (PI).
a. The manufacturing plant has a ten-year tax life, and Galaxy Industries Ltd uses Diminishing value method of depreciation for the plant using a 25% depreciation rate per annum. At the end of the project, (i.e., at the end of year 6), the plant can be scrapped for $ 22 million.
b. The project will incur $250 million per annum in fixed costs
c. Galaxy Industries Ltd will manufacture 300,000 commercial vacuum cleaners per year in each of the years and sell them at $ 2,200 per vacuum cleaner.
d. The variable production costs are $ 950 per vacuum cleaner.
e. At the end of year 6, the company will sell the land.
Note: Work all solutions to the nearest two decimals.
2.2. What are the pros and cons of using risk-adjusted costs of capital for individual investments?

Answer 1

	1	Initial Cash Flow
	A	After Tax value of land	$9,750,000
	B	Cost of plant	$275,000,000
	C	Initial net working capital	$7,950,000
	D=-(A+B+C)	Initial Cash flow	($292,700,000)
	2	Weighted Average Cost:
		Debt;
	E	Face value of Bonds	$120,000,000
	F=0.95*E	Total Market value of Bond	$114,000,000
	G	Par Value of each Bond	$1,000
	H=G*0.0725/2	Semiannual Coupon payment	$36.25
	I=20*2	Number of semiannual period	40
	J	Payment at maturity	$1,000
	K=0.95*1000	Current market Value per bond	$950
	L	Semi annual Bond Yield	3.87%	(Using RATE function of excelwith Nper=40,Pmt=36.25,PV=-950,Fv=1000)
	M=L*2*(1-0.28)	Cost of debt	5.58%
		Ordinary Shares
	P	Number of Shares	15,000,000
	Q	Market Price	$55
	R=P*Q	Total Market value	$                  825,000,000
	S	Dividend Growth Rate	0.068681656	((6/4.6)^(1/4))-1
	T=6*(1+S)	Next years dividend	6.412089935
	U=(T/Q)+S	Cost of Equity	0.185265109
	V	Cost of Equity in percentage	18.53%
		Preference shares
	W	Market Value	$384,000,000	($32* 12000000)
	X	Dividend per share	$0.65	(6.5% of $10)
	Y=X*12000000	Annualdividend	$7,800,000
	Z=Y/W	Cost of Preference shares	0.0203125
	Z	Cost of Preference shares in percentage	2.03%
					0.126229
	a=F+R+W	Total market Value of capital	$1,323,000,000
	b=F/a	Weight of Debt	0.0861678
	c=R/a	Weight of Common Shares	0.623582766
	d=W/a	Weight of Preference shares	0.290249433
	WACC=b*M+c*V+d*Z	Weighted Average Cost of Capital	12.62%