Question

Q 1

Healthy Foods Company (HFC) currently processes seafood with a unit it purchased several years ago. The unit, which originally cost $500,000, has a current book value of $250,000. HFC is considering replacing the existing unit with a newer, more efficient one. The new unit will cost $750,000 and will also require an initial increase in net working capital of $40,000. The new unit will be depreciated on a straight‐line basis over five years to a zero balance. The existing unit is being depreciated at a rate of $50,000 per year. HFC expects to sell the existing machine today for $275,000. HFC’s tax rate is 30%.If HFC purchases the new unit, annual revenues are expected to increase by $100,000 (due to increased capacity), and annual operating costs (exclusive of depreciation) are expected to decrease by $20,000. Annual revenues and operating costs are expected to remain constant at this new level over the five‐year life of the project. Accumulated net working capital will be recovered at the end of five years. HFC’s (Simplified) Balance sheet is below:

Assets Liabilities & Equity

Current Assets 200,000 Debt 480,000

Fixed Assets 1,000,000 Equity 720,000

HFC’s equity beta is 1.3, cost of debt is 10% and the risk‐free rate and market return are

8% and 14% respectively.

Answer the following

(a) Calculate the project’s initial net investment.

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(b) Calculate the annual net operating cash flows for the project.

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(c) Calculate HFC’s cost of equity and weighted average cost of capital.

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(d) Should HFC proceed with the project? Why?

Answer 1

(a) New unit cost = $750,000

Old unit expected selling price = $275,000

Old unit current book value = $250,000

Tax on profit on sell of old unit = ( $275,000 - $250,000 ) * 30%

= $25,000 * 30%

= $7,500

Increase in Net working Capital (NWC) = $40,000

Calculation of Initial Net Investment (at year 0)

Cost of New Unit $750,000

Add:  Increase in Net working Capital $40,000

Add: Tax on profit on sell of old unit     $7,500

Less: Old unit expected selling price ($275,000)  

  Net Initial Investment $522,500

(b)  Calculation of Annual Net Operating Cash Flow (From year 1 to 5)

Annual Revenue ( expected to increase )    $100,000

  Add : Decrease Cost (same impact as increase revenue ) $20,000

Less : Depreciation New ( 750,000 / 5 ) ($150,000)

Add : Opportunity cost on old depreciation ( 250,000 / 5 ) $50,000

Earning before Interest & Tax (EBIT) $20,000

Less : Tax @ 30% ($6,000)   

Earning after Tax (EAT) $14,000

Add: Incremental Depreciation ( New - Old ) $100,000   

Net Cash Flow $114,000

(c)

Cost of Equity (ke) = Risk free rate + Beta * ( Market return - risk free rate )

= 8% + 1.3 ( 14% - 8% )

= 8 + 1.3 * 6

= 8 + 7.8

= 15.8%

Cost of Debt (after tax) (kd) = Cost of debt * ( 1 - tax rate )

= 10 * ( 1 - 0.30 )

= 10 * 0.70

= 7%

weight of eqity (We) = 720,000 / 1,200,000 = 0.6

weight of debt (Wd) = 480,000 / 1,200,000 = 0.4

WACC (weighted average cost of capital) = ke * We + kd * Wd

= 15.8% * 0.6 + 7% * 0.4

= 9.48 + 2.8

= 12.28%

(d)

Accept : if replacement decision is wealth enhancing and create wealth.

Reject : if replacement decision diminish the wealth and fails to create wealth.

Calculation of Terminal Cash Flow (at year 5)

Increased revenue [after tax] ( 100,000 * 0.70 ) $70,000

+ Decreased Cost [after tax] ( 20,000 * 0.70 ) $14,000

+ Tax shield on Incremental Depreciation (100,000 * 0.30 )    $30,000

+ Working Capital Recovery $40,000

Net Cash Flow $154,000

Calculation of Net Present Value

Year	Cash Flow	PVIF @ 12.28%	Present Value of Cash Flow
0	- $522,500	1	- $522,500.00
1	$114,000	0.8906	$101,528.40
2	$114,000	0.7932	$90,424.80
3	$114,000	0.7065	$80,541.00
4	$114,000	0.6292	$71,728.80
5	$154,000	0.5604	$86,301.60
		Total	- $91,975.40

Net present value is difference of present value of cash inflows and present value of cash outflow.

PVIF = 1 / ( 1 + rate )ⁿ

Conclusion : HFC should not accept the project or not proceed with the project as NPV is negative.