Question

Your firm which is headquartered in US is considering a 5-year international project, an addition of new product line to your existing product lines in Europe. The new product line would require a purchase of new equipment with a price of €600,000. The equipment will be depreciated entirely to €0 using straight-line method for 5 years for the tax reporting purpose. The new product line is expected to generate €760,000 for year 1 and to increase its sales at a growth rate of 3% for next 4 years. After 5 years, the new product line will become useless. Production costs (excluding depreciation) are estimated at €500,000 for year 1 and will also increase by 3% per year. Selling and administration expenses will remain at € 90,000 per year. Net working capitals (NWC) is projected to remain at 10% of projected sale of each year and will be financed through operating cash flow at the end of each year. Any remaining NWC will be fully recovered in cash at the sale of the equipment at the end of fifth year. To finance this project (€600,000), you plan to issue 5-year annual euro-denominated bonds at par in Europe. According to your financial advisor, you can raise up to €300,000 by issuing 5-year annual 12% coupon bonds at par. However, you need to issue 5-year annual 14% coupon bonds at par for additional capitals above €300,000. Below is the information you will use to estimate the cost of capitals. Your target capital structure depends on whether you will issue new equities in Europe or US. You should choose only one equity market (US or Europe) to issue new equities. Equity Market US Europe Equity Risk Premium 6% 7% Risk free rate 4% 4% Beta 0.9 1.0 Target capital structure (Debt/(Debt+Equity)) 0.5 0.6 The project will pay a 40% tax rate. The current exchange rate between USD and Euro is $1/€ and remains constant. You assume that EBT (Earing Before Tax) is the same as taxable income. (You do not need to recalculate tax)

Q6) Regarding the equipment, calculate annual depreciation expense.

Q7) Estimate incremental cash flows to satisfy NWC requirement each year.

Q8) If you choose to issue new equities in Europe, you are expected to pay a dividend of €4 per share in first year and the dividend will increase at a rate 3% per year afterwards. 1. Calculate total amount of debts you need to issue in order to meet your target capital structure. 2. Calculate the number, not amount of equities(stocks) you need to issue (Use Gordon constant growth model) 3. Calculate after-tax cost of debts and cost of capitals. 4. Estimate annual expected cash flow from operation. 5. Calculate NPV

Q9) Assuming that you decide to issue new equities in US, 1. Calculate total amount of debts you need to issue in order to meet your target capital structure. 2. Calculate after-tax cost of debts and cost of capitals. 3. Estimate annual expected cash flow from operation. 4. Calculate NPV

Q10) Based on your answers to questions (3) and (4), 1. Which market (US or Europe) will you choose to issue new equities and why?

Answer 1

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