In: Finance
McCormick & Company is considering a project that requires an initial investment of $24 million to build a new plant and purchase equipment. The investment will be depreciated as a modified accelerated cost recovery system (MACRS) seven-year class asset. The new plant will be built on some of the company's land, which has a current, after-tax market value of $4.3 million. The company will produce bulk units at a cost of $130 each and will sell them for $420 each. There are annual fixed costs of $500 thousand. Unit sales are expected to be $150,000 each year for the next six years, at which time the project will be abandoned. At that time, the plant and equipment is expected to be worth $8 million (before tax) and the land is expected to be worth $5.4 million (after tax). To supplement the production process, the company will need to purchase $1 million worth of inventory. That inventory will be depleted during the final year of the project. The company has $100 million of debt outstanding with a yield to maturity of 8 percent, and has $150 million of equity outstanding with a beta of 0.9. The expected market return is 13 percent, and the risk-free rate is 5 percent. The company's marginal tax rate is 40 percent.
1. What will be the tax depreciation each year?
2. What will be the value of the plant and equipment for tax purposes in year six? Will it be sold for a gain or a loss, and what will the tax effect be?
3. What is the weighted average cost of capital (WACC)?
4. What is the salvage cash flow of the new equipment? Include the income tax effect.
5. What is the total operating cash flows, given the following
operating cash flows:
Sales = 150,000 x $420 = $63,000,000
Costs = 150,000 x $130 + $500,000 = $20,000,000
Answer 1:
Cost of Plant and Equipment = $24,000,000
Land cost is not depreciated
Project will be abandoned at the end of six years. Hence depreciation is calculated for 6 years.
Depreciation rates for modified accelerated cost recovery system (MACRS) seven-year class asset and annual tax depreciation from year 1 to year 6 are calculated as follows:
Answer 2:
Value of the plant and equipment for tax purposes in year six = $3,213,600
Calculations are as below:
As the plant and equipment is expected to be worth $8 million (before tax) at the end of year 6, it will be sold at a gain.
Gain = $8,000,000 - $3,213,600 = $4,786,400
Tax effect = Gain * Tax rate
= $4,786,400 * 40%
= $1,914,560
Answer 3:
Cost of Equity = Risk free rate + Beta * (Market Rate of return - Risk free rate)
= 5% + 0.9 * (13% - 5%)
=12.2%
Weighted average cost of capital (WACC) = Cost of Equity * (Value of Equity / Total Value) + Cost of Debt * (1 - Tax rate) * (Value of Debt / Total Value)
Total value =Value of equity + Value of debt
= $150 million + $100 million = $250 million
Hence,
WACC = (12.2% * 150/250) + [8% * (1 - 40%) * 100/250]
= 9.24%
Answer 4:
Salvage cash flow of the new equipment = Salvage Value - Tax Effect
= $8,000,000 - $1,914,560
= $6,085,440
Answer 5:
Operating cash flows are calculated below: