Question

Horizon Co is a manufacturing company that wishes to evaluate an investment in new production machinery. The machinery would enable the company to satisfy increasing demand for existing products and the investment is not expected to lead to any change in the existing level of business risk of Horizon Co. The machinery will cost Rs.2·5 million, payable at the start of the first year of operation, and is not expected to have any scrap value. Annual before-tax net cash flows of Rs. 680,000 per year would be generated by the investment in each of the five years of its expected operating life. These net cash inflows are before taking account of expected inflation of 3% per year. Initial investment of Rs. 240,000 in working capital would also be required, followed by incremental annual investment to maintain the purchasing power of working capital.

Horizon Co has in issue five million shares with a market value of Rs. 3·81 per share. The equity beta of the company is 1·2. The yield on short-term government debt (Risk free rate) is 4·5% per year and the equity risk premium is approximately 5% per year. The debt finance of Horizon Co consists of bonds with a total book value of Rs. 2 million. These bonds pay annual interest before tax of 7%. The par value and market value of each bond is Rs. 100. 2 Horizon Co pays taxation one year in arrears at an annual rate of 25%. Capital allowances (taxallowable depreciation) on machinery are on a straight-line basis over the life of the asset.

Required:

a. Calculate the after-tax weighted average cost of capital of Horizon Co. b. Prepare a forecast of the annual after-tax cash flows of the investment in nominal terms, and calculate and comment on its net present value.

Answer 1

Cost of equity, as per CAPM=

RFR=(Beta*market risk premium)

ie. 4.5%+(1.2*5%)=

10.50%

After-tax cost of debt=

Before-tax cost*(1-Tax rate)

ie.7%*(1-25%)=

5.25%

Calculation of WACC
Type of capital	Mkt. values	Wt. to Total	Cost	Wt.* Cost
Equity (5000000*3.81)	19050000	90.50%	10.50%	9.50%
Debt(BV=Mkt. value)	2000000	9.50%	5.25%	0.50%
Total	21050000	100.00%	WACC	10.00%

a.The after-tax weighted average cost of capital of Horizon Co.=

10.00%

NPV calculations
Year	0	1	2	3	4	5
1.Initial cost	-2500000
Annual before-tax nominal cash inflows(Prev.*1.03)		700400	721412	743054.4	765346	788306.4
Tax at 25%(paid in 1 yr.arrears)			-175100	-180353	-185763.6	-191336
Annual after-tax nominal cash inflows(Prev.*1.03)		700400	896512	923407.4	951109.6	979642.9
Add: Depn. Tax shield(2500000/5*25%)			125000	125000	125000	125000
2.AT nominal CFs		700400	1021512	1048407	1076110	1104643
NWC reqd.(240000*1.03 from yr. 1& so on)	240000	247200	254616	262254.5	270122.1	0
3. Change in NWC	-240000	-7200	-7416	-7638.48	-7867.634	270122.1
4. Annual net nominal CFs(1+2+3)	-2740000	693200	1014096	1040769	1068242	1374765
5. PV F at 10%,(1/1.1^Yr.n)	1	0.90909	0.82645	0.75131	0.68301	0.62092
6.PV at 10%(4*5)	-2740000	630181.8	838095.9	781945.1	729623.6	853620.9
7.NPV at 10%	1093467.26
NPV of nominal cash flows is POSITIVE at the nominal WACC of 10%