Question

Part A: ABC Inc. is considering a proposal to manufacture a new product and add it to the existing lines of their products. The project requires the use of an existing warehouse, which the firm acquired three years ago for £1 million and which it currently rents out for £120,000 per year. Rental rates are not expected to change going forward. In addition to using the warehouse, the project requires an up-front investment into machines and other equipment of £1.4m. This investment can be fully depreciated straight-line over the next 10 years for tax purposes. However, ABC Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for £500,000. Finally, the project requires an initial investment into net working capital equal to 10% of predicted first-year sales. Subsequently, net working capital is 10% of the predicted sales over the following year and it is fully recovered at the end of the project. Sales of the new product are expected to be £4.8 million in the first year and to stay constant for eight years. Total manufacturing costs and operating expenses (excluding depreciation) are 80% of sales, and profits are taxed at 30%. [15 marks]

i. What are the free cash flows of the project? Show your calculations.

ii. If the cost of capital is 15%, what is the NPV of the project?

Part B: Colgate-Palmolive Company has just paid an annual dividend of £1.50. Analysts are predicting dividends to grow by £0.12 per year over the next five years. After then, Colgate's earnings are expected to grow 6% per year, and its dividend payout rate will remain constant.

If Colgate's equity cost of capital is 8.5% per year, what price does the dividend-discount model predict Colgate stock should sell for today? [10 marks]

Answer 1

Part-A
i.Free cash flows of the project:
Year 0 CFs
Upfront investment	-1400000
NWC introduced & recovered(4800000*10%)	-480000
Total Yr. 0 CFs		-1880000
Yrs.1-7 CFs
Sales	4800000
Mfg.costs & opg. Exp.(4800000*80%)	-3840000
Depreciation(1400000/10)	-140000
Rent lost	-120000
EBT	700000
Tax at 30%	-210000
EAT	490000
Add back:depn.	140000
Opg. CF/FCF		630000
Yr. 8 CFs
1.Opg. CFAs above	630000
2.NWC recovered	480000
ATCF from sale of m/cs & eqpt.
Cost	1400000
Acc. Depn.(1400000/10*8)	1120000
Carrying value	280000
sale value	500000
Gain on sale	220000
tax on gain at 30%	66000
3.ATCF on sale(500000-66000)	434000
Total Yr. 8 FCFs (1+2+3)		1544000
ii.NPV at COC 15%
Year 0 FCFs		-1880000
PV of Yrs.1-7 FCFs	630000*4.16042=	2621065
(P/A,i=15%,n=7 yrs.=4.16042)
PV of Yr. 8 FCF	1544000*0.32690=	504734
(P/F,i=15%,n=Yr.5=0.32690)
NPV of FCFs at COC 15%		1245798

Part B
Div. &yr.	Dividends		PV F at 8.5%	PV at 8.5%
1	2	3	4=1/1.085^Yr.n	5=3*4
D1	1.50+0.12=	1.62	0.92166	1.49309
D2	1.62+0.12=	1.74	0.84946	1.47805
D3	1.74+0.12=	1.86	0.78291	1.45621
D4	1.86+0.12=	1.98	0.72157	1.42872
D5	1.98+0.12=	2.1	0.66505	1.39660
D5/ P5=
D6/(r-g)	(2.1*1.06)/(8.5%-6%)=	89.04	0.66505	59.21564
P0= Price today at Yr.0=				66.46831
			ie.	66.47
				(Answer)