Question

(Set the entire homework up in an Excel spreadsheet and answer all the questions clearly marked in your spreadsheet.)

You are considering purchasing a machine (use your imagination) that will initially cost $205,000.00. The machine is expected to last 7 years, and you project that you can sell the worn out machine at the end of 7 years for $55,000.00

Annual operating cash inflows and outflows are projected as follows, and are assumed to occur at the end of each year:   Both of years 1 and 2, cash inflow $66,000.00, cash outflow expenses $24,000.00; both of years 3 and 4, cash inflow $72,000.00, cash outflow expenses $27,000.00. In year 5 you have to shut down and rebuild the machine so cash inflows are only $35,000.00 and cash outflows are $44,000.00. In year 6 cash inflow is $65,000.00, and cash outflow expenses are $39,000.00. Finally, in year 7 cash operating inflow is $66,000.00 and cash operating expenses are $34,000.00.

3. Assume your firm can lock in a cost of Debt for this project at 6% (.06) annual rate. Also, assume the stockholders in your firm expect a return on equity that is 2 percentage points higher than the cost of debt.

3.a. Explain why the cost of equity for a proposed project like this would be higher than the cost of debt.

3.b. Your firm expects to finance this machine using 50% equity, and 50% debt. Calculate the weighted cost of capital that would be used in for an NPV analysis given these facts.

4. Calculate the net present value of this investment using the =NPV function in Excel using the weighted cost of capital that you calculated in 3.b.

4.b. Assuming the cash flow projections are all correct, and you can “lock in” your weighted cost of capital for the life of the project, would this project have a positive or negative impact on your companies’ wealth?

5. Calculate the Internal Rate of Return on this investment using the IRR function in Excel.

5.b. Could this proposed capital investment generate more than one possible IRR?   Explain why or why not.

Answer 1

3a.
Cost of Equity for capital investment will be higher than cost of debt as equity
owners take more risk that creditors. There is a mandatory requirement to pay
the interest and principal back on debt. So debt is effectively riskless. But the
return on equity is uncertain and depends on the success of the project or
company. Therefore cost of equity is more than cost of debt for carrying
greater risk.

3b. Cost of Debt =6%

Cost of Equity =6%+2%=8%

Debt : Equity =50%:50%

So WACC =0.5*6%+0.5*8% =7%

	Finding NPV :
	Details	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
a	Initial Investment	(205,000)
	Operating Cash flow
	Cash Inflow		66,000	66,000	72,000	72,000	35,000	65,000	66,000
	Cash outflow		24,000	24,000	27,000	27,000	44,000	39,000	34,000
b	Net Operating Cash inflow		42,000	42,000	45,000	45,000	(9,000)	26,000	32,000
c	Terminal cash inflow								55,000
d	Total Free cash flow from project=a+b+c	(205,000)	42,000	42,000	45,000	45,000	(9,000)	26,000	87,000
e	NPV using excel function @WACC7%=	7,087.70
f	IRR using excel =	7.96%

ans4b.
As the NPV of the project using discount factor 7% is positive, we can say that the project will have a positive
impact on the health of the company.
IRR as calculated above is 7.96%

Ans 5b
As there is one net cash outflow in year 5, there is a possibility
that there will be more than one IRR for the project. This
happens for such projects with non regular cash flow as
the irregular outflow sets of inflow in the calculation and may give
two rates that will make NPV zero.