In: Finance
Company DEF needs advice regarding its investment decisions.
Investment alternative A which the company is currently evaluating
is a new machine with an initial outlay of $2,000,000, economic
life of 4 years and no residual value. The machine will be related
to an incremental annual revenue of $1,000,000 and incremental
annual costs of $320,000. The machine will be depreciated on a
straight-line basis.
Some time ago, DEF has issued bonds with total face value of
$18,000,000 which pay annual coupons of 7.5% and have a maturity
date in 9 years. The yield on comparable bonds in the market is 6%.
DEF has a total of 4,200,000 outstanding shares with a current
price of $4.21 each. The average return on the equity market index
is 8.9% while the yield on government bonds is 3.2%. The company’s
beta is 1.44. Furthermore, the company has 1,500,000 preference
shares with a face value of $1, a coupon rate of 8%, and a current
market price of $0.85 each. The company’s tax rate is 20%.
A. Calculate the company’s after-tax WACC.
B. Evaluate investment project A using the NPV and IRR methods of
capital budgeting and provide an investment decision according to
each of these criteria. Use the approximation method for
calculating the IRR.
C. DEF is considering as a second alternative the project B with an
initial outlay of $1,500,000 and incremental after-tax cash flows
of $560,000, $460,000, $400,000, $320,000 and $300,000 for years 1
to 5, respectively. Project A and Project B are mutually exclusive.
Which project should be chosen based on the constant chain of
replacement assumption? Hint: Calculate the equivalent annual
annuity (EAA).
A) Company's after -tax WACC
N= 9
I/y= 6%
Pmt= 7.5% × 1,000 = 75
Fv= 1,000
Pv= compute
We get, present value of the bond as $1,102.03
Market value of bond = 1,102.03 × 18,000 = $19,836,540
After tax yield of bond = yield (1 - tax)
= 6% ( 1 - 0.20)
= 6% (0.80)
= 4.8%
Cost of equity = risk free rate + beta (market return - risk free rate)
= 3.2% + 1.44 (8.9% - 3.2%)
= 3.2% + 1.44 (5.7%)
= 3.2% + 8.21%
= 11.41%
Market Value of equity = 4,200,000 × 4.21 = $17,682,000
Cost of preference share = Dividend / market price
= 0.08 / 0.85
= 0.0941 or 9.41%
Market value of preference share = 0.85 × 1,500,000 = 1,275,000
Total Investment = bond + equity + preference share
= 19,836,540 + 17,682,000 + 1,275,000
= $38,793,540
Weight of equity = 17,682,000 / 38,793,540 = 0.4558
Weight of bond = 19,836,540 / 38,793,540 = 0.5113
Weight of preference share = 1,275,000 / 38,793,540
= 0.0329
WACC= weight of debt × after tax cost of debt + weight of equity × cost of equity + weight of preference share × cost of preference share
= 0.5113 × 4.8% + 0.4558 × 11.41% + 0.0329 × 9.41%
= 2.45% + 5.2% + 0.31%
= 7.96%
B) cash inflow (year 1 to 4) = (sales - cost - depreciation) (1-tax) + Depreciation
= (1,000,000 - 320,000 - 500,000) (1 - 0.20) + 500,000
= (180,000) (0.80) + 500,000
= 144,000 + 500,000
= $644,000
Using financial calculator to find the NPV of project A
Inputs: C0= -2,000,000
C1= 644,000. Frequency= 4
I= 7.96%
NPV= compute
We get, NPV of the Project A as $134,910.20
IRR
Using financial calculator to calculate the IRR
Inputs: C0= -2,000,000
C1= 644,000. Frequency= 4
IRR= compute
We get, IRR of the project B as 10.953%
C) Using financial calculator to calculate the NPV
Inputs: C0= -1,500,000
C1= 560,000. Frequency= 1
C2= 460,000. Frequency= 1
C3= 400,000. Frequency= 1
C4= 320,000. Frequency= 1
C5= 300,000. Frequency= 1
I= 7.96%
We get, NPV of the project as $171,376.57
Equivalent Annual Annuity
Project A
Using financial calculator to calculate the EAA
Inputs: N= 4
I/y= 7.96%
Pv= -134,910.20
Fv= 0
Pmt= compute
We get, EAA as Project A as $40,695.94
Project B
Using financial calculator to calculate the EAA
Inputs: N= 5
I/y= 7.96%
Pv= -171,376.57
Fv= 0
Pmt= compute
We get, EAA as Project B as $42,877.13
If the projects are mutually exclusive, we should Select project B as it has higher EAA.