Question

Question 3: Application of finance-capital budgeting (20 Marks)

Kogan.com is considering investing in a new fleet of delivery trucks, costing $10,000,000 today. In the first year of the project, it is expected to yield revenue of $4,000,000 and this is expected to grow at 10% p.a. for another 2 years. Operating costs are expected to be 15% of annual revenue. The project will be terminated at the end of the third year and the entire fleet is expected to be sold for 10% of the original cost.

Kogan.com is financed 70% through debt which has a cost of 8% and shareholders expect a 12% return on their equity.

Show all your workings when calculations are required and round off your FINAL result to TWO decimal places.

a) Set out the project time line complete with cash inflows, outflows and net cash flows by year. (6 marks)

b) Determine the required rate of return of Kogan.com to be used as the discount rate in the analysis of this project. (3 marks)

c) What is the Net Present Value (NPV) of this project? Explain if this project should be accepted according to the NPV rule. (4 marks)

d) What is the Internal Rate of Return (IRR) of this project? Explain if this project should be accepted according to the IRR rule. (3 marks)

e) Identify which of the following changes may lead to an increase in the required rate of return for this project and briefly explain why and why not. (4 marks)

Holding everything else being equal,

The credit risk of Kogan.com unexpectedly increases The proportion of debt of the total fund raised for the project increases

Answer 1

	Kogan.com
	Ans a.
	Cash flow Outline	Year 0	Year 1	Year 2	Year 3
a	Initial Investment in Trucks	$ (10,000,000)
	Cash flow from Operations
	Annual Revenue with 10% increase		$               4,000,000	$    4,400,000	$       4,840,000
	Less Operating Costs @15% of revenue		$                (600,000)	$     (660,000)	$         (726,000)
b	Net Cash flow from Operations		$               3,400,000	$    3,740,000	$       4,114,000
c	Terminal cash flow=Truck sale value @10% of original cost				$       1,000,000
d	Total Net Cash flows from Project=a+b+c	$ (10,000,000)	$               3,400,000	$    3,740,000	$       5,114,000

Ans b.

Finding WACC or required rate of return for ptoject

Debt/Equity =70%/30%

Cost of Debt =8%

Cost of Equity=12%

WACC=70%*8%+30%*12%=9.2%

So Discount rate for the Project is 9.2%

	Ans c
	NPV Calculation :
	Cash flow Outline	Year 0	Year 1	Year 2	Year 3
d	Total Net Cash flows from Project=a+b+c	$ (10,000,000)	$               3,400,000	$    3,740,000	$       5,114,000
e	PV /Discount Factor @9.2% =1/1.092^n	1	0.9158	0.8386	0.7679
f	PV of Net cash flow=d*e=	$ (10,000,000)	$               3,113,720	$    3,136,364	$       3,927,041
g	NPV=Sum of PV of Cash flows=	$         177,125
	As the project NPV is positive, it should be accepted as per NPV rule.

	Ans d.
	IRR (Usinf Excel formula)=	10.13%
	As the IRR is more than the discount rate, the project should be accepted as per IRR rule.

Ans e.
1. When the credit risk of Kogan.com unexpected ly increases and other things being equali, the
cost of debt will increase to compensate for the increased risk, so the required rate of return
will also increase.
2. When other things being equal, the increase in debt portion of total fund will reduce the WACC
as debt is cheaper than equity, assuming the increased debt % not increases debt cost .
Therefire, the required rate of return for the project will also increase.