Question

To illustrate and further support our strategic financial planning systems we need to show the CFO and management team an example of the application of the previously constructed WACC. The CFO thinks that showing management how we can validate and choose projects based on expected returns developed from the WACC will help reduce risk of our investor's capital thus lowering the required rate of return we would have to provide to those investors. If we lower our expected return we can then do more projects and grow at a faster rate.

He has asked your team to evaluate the following project:

Capital investment: Acme is planning construction of a new loading ramp for its single iron mill. The initial cost of the investment is $1 million. Efficiencies from the new ramp are expected to reduce costs by $100,000 for the life of the plant which is currently estimated at another 30 years. The $100,000 cost savings is per year for the 30 year life of the project. When will this project break-even on a simple cash basis and a discounted cash basis. What is the NPV of the project if Acme has an after tax cost of debt of 8% and a cost equity of 12% (they are currently funded equally by debt and equity)?

Concept Check: We need to adjust cash flows to account for things like inflation, our cost of capital and opportunity costs. Simply looking at cash flow not adjusted for some of these costs will lead to taking on projects which are not really adding to the value of the organization.

Helpful Hint: The first step in conducting an NPV analysis is to include all the relevant cash flows. This includes savings from taxes and any expenses directly related to the venture. We reject any project with a negative NPV.

Answer 1

WACC to discount the cah flows of the project=

(Wt.d*kd)+(Wt. e*ke)

ie.(50%*8%)+(50%*12%)=

10%

Simple cash basis
Initial investment	-1000000
Total Reduction in cost/savings (100000*30)	3000000
Net savings over initial investment	2000000
The project breaks even, ie initial cost is recovered in
1000000/100000=
10 Yrs,.

Discounted basis:
Initial investment	-1000000
Reduction in cost/savings per year=100000
PV of the above cost savings
100000*(1-1.1^-30)/0.1=	942691
NPV of the project at 10% WACC=	-57309
IRR=
0=-1000000+(100000*(1-(1+r)^-30)/r)
r=9.31%
IRR< WACC
As the NPV , ie. Net of positive & negative cash flows is NEGATIVE (-57309), it is evident that the project DOES NOT BREAK-EVEN on a discounted cash basis --during the 30 years.

The project is not recommended on the  discounted basis.