Question

the antimarino aircraft corp is considering the following two mutually exclusive investment options:

1) annuity revenues each year will be $100. total costs(fixed costs + variable costs) will be $80 each year. ( for simplicity assume there is no depreciation expense. initial net working capital requirements are $20 at start up, and will not grow. the firm will make a capital expenditure of $250 at startup and have annual expenditures of $10 at the end of each year. the project will last 20 years. the firm will have $200 dollars of debt and $200 dollars of equity.

2) growing perpetuity- revenues in the first year will be $100. revenues will grow at 5% per year. total costs will be $80 in the first year and will also grow by 5% per year ( assume no depreciation expense). initial net working capital requirements are $20 at startup and will grow by 5% per year. the firm will make a capital expenditure of $250 start up, plus annual expenditures of $10 at the end of the first year and will grow by 5% per year. the firm will have $300 of debt and $100 of equity.

Regardless of which option they choose, the following facts will hold true:

cost of debt = 7% beta = 1.2

tax rate =25% t note rate =3% market return =14%

which project should they choose?

Answer 1

The firm should choose option 2 as it has positive NPV.

Cost of debt, Kd = 7%; Cost of equity, Ke = Rf + Beta x (Rm - Rf) = 3% + 1.2 x (14% - 3%) = 16.2%; Tax rate, T = 25%

Option 1: Capital structure:

Debt, D = 200; Equity, E = 200

Hence, Wd = proportion of debt = D / (D + E) = 200 / (200 + 200) = 0.5

We = proportion of equity = 1 - Wd = 1 - 0.5 = 0.5

Hence, discount rate = WACC = r = Wd x Kd x (1 - T) + We x Ke = 0.5 x 7% x (1 - 25%) + 0.5 x 16.2% = 10.725%

Please see the table below. Please be guided by the second column titled “Linkage” to understand the mathematics. The last row highlighted in yellow is your answer. Figures in parenthesis, if any, mean negative values. All financials are in $. Adjacent cells in blue contain the formula in excel I have used to get the final output.

Option 2: Capital structure:

Debt, D = 300; Equity, E = 100

Hence, Wd = proportion of debt = D / (D + E) = 300 / (300 + 100) = 0.75

We = proportion of equity = 1 - Wd = 1 - 0.75 = 0.25

Hence, discount rate = WACC = r = Wd x Kd x (1 - T) + We x Ke = 0.75 x 7% x (1 - 25%) + 0.25 x 16.2% = 7.988%

The firm should choose option 2 as it has positive NPV.