Question

john is the president of a consulting firm named Dye Optimalization from Intellectural Thinking (DO-IT). Suppose DO-IT is thinking about undertaking a project to expand its current business activities by creating an advisory business that will enable clients to benefit from distance learning coupled with interactive sessions.

DO-IT is a publicly traded company that has a stock price of

$24 per share with 2,000,000 shares outstanding. In addition, DO-IT has outstanding debt with a face value of $10,000,000 that is currently selling at a price of 120% with a yield of 6%.

The risk free rate currently is 3% and DO-IT's equity cost of capital is 12%. The DO-IT company is a profitable firm that pays a corporate tax rate of 25%.

john is considering a project that would require an immediate expenditure of $750,000 for equipment to expand its current business activities. This equipment would have a 3 year life with zero salvage value and zero disposal cost; and the equipment will be depreciated via the straight line depreciation method. Prior to considering depreciation expense and tax effects, the equipment itself will be responsible for generating additional gross profits of $475,000 annually for each of the 3 years of its useful life. Also, the project and equipment have no impact on net working capital.

Should DO-IT make the purchase? Be sure to show all your work and clearly put forth your thought process.

Answer 1

calculation:

	Cost of the machine		7,50,000
	life in years			3
	depreciation per annum		250000
	additional gross profits p.a	4,75,000
less	interset(750000*6%*.25)		11,250
	depreciation		250000
	Profit before tax		2,13,750
	tax @ 25%			53,437.50
	Profit after Tax		1,60,312.50
	cost of capital(750000*12%*.75)	67500
			net benefit	92,812.50
			for 3 years	2,78,437.50

Bond yield		6%
trading at		120%
cost of debt		5.00%
cost of equity	12%
Debt Equity Ratio:		0.25
Outstanding Debt	12000000
Outstanding equity	48000000
24*2000000

so it is recomemded to buy the equipment