Question

QUESTION 2: WEIGHTED AVERAGE COST OF CAPITAL
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:
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.

Answer 1

Weighted Average Cost of Capital Workings:

Before-tax Cost of debt

PV of a bond=PV of its future coupons+Pv of Face value to be received at maturity

ie. (95%*1000)=((7.25%/2*1000)*(1-(1+r)^-40)/r)+(1000/(1+r)^40)

Solving the above

we get the semi-annual yield to maturity as

3.87%

Converting to annual Yield

(1+3.87%)^2-1=

7.89%

So, the after-tax cost of debt=

7.89%*(1-28%)=

5.68%

Cost of Equity
Growth Rate of Dividends
Year	Dividends	Growth rate(Yr1-Yr.0)Yr.0
-4	4.6
-3	4.8	4.35%
-2	5.3	10.42%
-1	5.5	3.77%
0	6	9.09%
Average growth rate=sum growth/4		6.91%

Applying growth rate of dividends,

Dividend on new -equity will be

6*(1+av. Growth rate of dividends)

ie.6*(1+0.0691)=

6.41

Cost of Equity= Next Dividend/ current Market price

ie. 6.41/55=

11.65%

Cost of Non-redeemable Preference shares

Dividend/Market price

ie.(10*6.5%)/32=

2.03%

Weighted Average Cost of Capital
Type of capital	Market value	Wt.to total MV	Cost	Wt. *Cost
Debt	120000000	9.03%	5.68%	0.0051
Ordinary shares (15000000*55)	825000000	62.08%	11.65%	0.0723
Non-redeemable Preference shares(12000000*32)	384000000	28.89%	2.03%	0.0059
Total	1329000000	1		0.0833
WACC = 8.33%

NPV /IRR/PI calculations for the 6-Year project	Year 0	1	2	3	4	5	6
Cost to build	-275000000
After-tax opportunity cost of land	-9750000
NWC introduced & recovered	-7950000						7950000
After-tax salvage of plant							29544346
After-tax sale of land							14000000
CAPEX & WC cash flows---------------------------1	-292700000	0	0	0	0	0	51494346
Operating cash flows
Sales		660000000	660000000	660000000	660000000	660000000	660000000
Less: Variable costs		285000000	285000000	285000000	285000000	285000000	285000000
Less: Fixed costs		250000000	250000000	250000000	250000000	250000000	250000000
Less: Depreciation		68750000	51562500	38671875	29003906	21752930	16314697
EBT		56250000	73437500	86328125	95996094	103247070	108685303
Less: tax at 28%		15750000	20562500	24171875	26878906	28909180	30431885
EAT		40500000	52875000	62156250	69117188	74337891	78253418
Add Back: Depreciation		68750000	51562500	38671875	29003906	21752930	16314697
Annual Operating cash flows-----------------------2		109250000	104437500	100828125	98121094	96090820	94568115
Net annual cash flows	-292700000	109250000	104437500	100828125	98121093.8	96090820	146062461
PV F at 8.33%	1	0.92311	0.85212	0.78660	0.72611	0.67028	0.61874
PV at 8.33%	-292700000	100849257	88993642	79311372	71247135	64407758	90374552
Sum PV at 8.33%	202483716
Less:PV of Loss of depreciation tax shields for yrs. 7-10	-4898960
NPV of the project	197584756
IRR of the project	18.47%
Profitability Index =1+(NPV/Initial Investment
1+(197584756/275000000)=	1.72

WORKINGS:
After-tax cash flow on salvage of plant
Salvage value	22000000
Book value	48944092
Loss on salvge	26944092
Tax cash outflow saved on loss	7544346
So, after-tax cash flow on salvage	29544346

Year	Depn.	WDV	Tax shield at 28%	PV F at 8.33%	PV at 8.33%
	Cost	275000000
1	68750000	206250000
2	51562500	154687500
3	38671875	116015625
4	29003906	87011719
5	21752930	65258789
6	16314697	48944092
7	12236023	36708069	3426086	0.571161	1956848
8	9177017	27531052	2569565	0.527242	1354783
9	6882763	20648289	1927174	0.4867	937955
10	5162072	15486217	1445380	0.449275	649374
				Sum PV	4898960