Question

Your company is looking at setting up a manufacturing plant overseas to manufacture driverless flying cars. The company bought some land in that that was just appraised for $3.8 million after tax. The proposed project will last five years. It is expected that you can sell the land at the end of 5 years for $4.1 million. The manufacturing plant will cost $34 million to build.

The following market data on your company are current.

Debt: 195,000 bonds with a coupon rate of 6.2 percent outstanding, 25 years to maturity, selling for 106 percent of par; the bonds make semiannual payments.

Common Stock:    8,100,000 shares outstanding, selling for $63 per share; the beta is 1.1.

7 percent expected market risk premium and 3.1 percent risk free rate.

Your underwriter tells you the floatation costs for common stock, preferred stock, and debt are 7%, 5%, and 3% respectively. The corporate tax rate is 21%. The project requires $1.5 million in initial net working capital which will no longer be required at the end of the project.

a)      This project is riskier than the typical project that your company normally undertakes. You have been told to adjust the risk factor by +2 percent. Calculate the appropriate discount rate to use when evaluating this project.

b)      Calculate the average cost of floatation.

c)       The manufacturing plant uses straight line depreciation to zero for the life of the project. At the end of the project (that is at the end of 5 years) the plant and equipment can be scrapped for $4.9 million. What is the after tax salvage value of this plant and equipment?

d)      The company will incur $6.9 million in annual fixed costs. The plan is to manufacture 121 driverless flying cars per year and sell them for $1,145,000 each; the variable costs are $950,000 per unit. What is the annual operating cash flow (OCF) per year for the project?

e)      What is the IRR and NPV of this project?

Answer 1

a.

Discount rate = risk free rate + (beta* market risk premium) + project risk factor = 0.031 + (1.1*0.07) + 0.02 = 0.128= 12.8%

b.

fist find value of bond

value of bond = =pv(rate,nper,pmt,fv,type) =pv(0.064,50,32.86,1060,0) = $534.13

pv = present value of bond

rate = discount rate semi annual= 12.8% /2 = 6.4%

nper = year*2 = 25*2 = 50

pmt = semi annual coupon = $1060*0.062 / 2 =$32.86

fv = face value of bond = $1060

total bond value (debt) = no of bond * value of bond = 195000*$534.13 = $104156590.6

value of equity = share price * no of share outstanding = $63 * 8100000 = $510300000

total asset value = value of debt + value of equity = $104156590.6 + $510300000 =$614456590.6

weight of equity = $510300000 / $614456590.6 = 0.8304

weight of equity = $104156590.6 / $614456590.6 = 0.1695

average cost of floatation = ( cost of equity * weight of equity) + (cost of debt * weight of debt)(1-tax rate) = (0.07*0.8304) + (0.03*0.1695)(1-0.21) = 0.05813+0.00402 = 0.0622 = 6.22%

c

. if we use straight line method then end of 5 year book value = 0

after salvage value = before tax salvage value - (sal value - book value ) t = $4.9 million - (4.9 million - 0)0.21 = $4.9 M - 1.029 M = $3.871 M

D

depreciation = value of project / life in year = $34 M / 5 = $ 6.8 M

annual operating cash flow = (sales - operating exp - depreciation)(1-tax rate) + depreciation

sales = 121 * $1145000 = ($138545000 - $121850000 - $6800000)(1-0.21) + $6800000 = $7817050 + $6800000 = $14617050

operating exp = fixed exp + variable exp = $6900000 + (121* $950000) = $6900000 + $114950000 = $121850000

note depreciation is non cash exp so we will ignore , but we will consider for tax calculation.