In: Finance
Use the following information to answer the next 5 questions.
Your corporation is considering investing in a new product line. The annual revenues for the new product line are expected to be $306000 with variable costs equal to 50% of these sales. In addition annual fixed costs associated with this new product line are expected to be $59900. The old equipment currently has no market value. The new equipment cost $55400. The new equipment will be depreciated to zero using straight-line depreciation for the three-year life of the project. At the end of the project the equipment is expected to have a salvage value of $29000. An increase in net working capital of $59000 is also required for the life of the project. The corporation has a beta of 0.7, a tax rate of 37%, and a target capital structure consisting of 54% equity and 46% debt. Treasury securities have a yield of 2.8% and the expected return on the market is 10%. In addition, the company currently has outstanding bonds that have a yield to maturity of 7.5%.
A.) What is the total initial cash outflow? (Show your answer to the nearest dollar as a negative number without dollar signs, commas, or decimals.)
b. What are the estimated annual operating cash flows? (nearest dollar)
c. What is the terminal cash flow? (nearest dollar)
d. What is the WACC? (4 decimals)
e. What is the NPV for this project? (nearest dollar)
A). Initial cash outflow of the project is $114,400
initial cash outflow = cost of new equipment + increase in Net working
initial cash outflow = ($55400 + $59000) = $114,400
B.) Yearly operating Cash Flow is $65,486
Annual Sales |
$306,000 |
Variable costs ( 50% of $306,000 ) |
($153,000) |
Fixed costs |
($59,900) |
Depreciation ($55400 / 3) |
($18,467) |
Earnings before tax |
$74,633 |
Taxes (37%) |
($27,614) |
Earnings after tax |
$47,019 |
Add Non-cash expenses(depreciation) |
$18,467 |
Yearly operating Cash Flow |
$65,486 |
C.) Terminal cash flow of the project is $77,270
Terminal cash flow = NSV of project assets + Recovered Net working capital
=Salvage value * (1-tax rate)
= $29,000 * (1-.37)
= $29,000 * .63
= $18,270
Recovered Net working capital = $59,000
Therefore, Terminal cash flow =$18,270 + $59,000 = $77,270
D.) The weighted average cost of capital is 8.02%
EXPLANATIONS: -
For the calculation of WACC we have to find the following:
1. Cost of Equity or required Rate of return on equity
the formula for cost of equity under CAPM model is Ke = Rf + β( Rm-Rf)
Where,
Ke= Required Rate of Return
Rf= Risk-Free Rate
Km=Expected Return On the Market Portfolio
β = Beta coefficient for the company
Here,
Rf= 2.8%
Km=10%
B = 0.7
Ke = 2.8 + .7(10 – 2.8)
Ke = 10.84%
Cost of Equity = 10.84%
Weight of equity = .54
2. After cost of the bond
the equation for the after tax cost of bond= Kd (1-t)
Where,
Kd= before tax cost of bond
t = firm's marginal tax rate
after tax cost of bond = 7.5% *(1-.37)
= 7.5% * .63
= 4.725%
Weight of bond = .46
Capital component |
weight |
after tax cost |
WACC |
Bond |
.46 |
4.725% |
2.1735% |
Common(internal) equity |
.54 |
10.84% |
5.8536% |
total |
1 |
8.02% |
E.) NPV of the project is $115608
NPV = operating cash flow * (PVIFA 8.02%, 30 + terminal cash flow * (PVIF 8.02%, year3) – initial investment.
NPV = ($65,486 * 2.57917) + ($77,270 * .79339) - $114,400
NPV = ($168,703 + $61,305) - $114,400
NPV = $115608