Question

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)

Answer 1

A). Initial cash outflow of the project is $114,400

initial cash outflow = cost of new equipment + increase in Net working

1.cost of new equipment = $55400

2.increase in Net working capital = $59000

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

NSV of project assets

=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 + B( Rm-Rf)

Where,

Ke= Required Rate of Return

Rf= Risk-Free Rate

Km=Expected Return On the Market Portfolio

B = 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