Question

OASIS Cables Company is considering a new project of introducing a new type of “Twisted Shield Cables” to the market. In order to produce the cable, a machine must be purchased for O.R 2.5 million with 5 years of economic life. The marketing department of the company has already run a research on the potential customers to identify the prospect of this product. An independent consultant was also hired to identify the prospective sales. Total cost of running research and hiring consultant was O.R 500,000. According to their combined projections, in the first year the company will be able to sell 40,000 meters of the shield cable at a price of O.R 40 per meter. The selling price per meter is expected to remain the same during the 5-year life of the project. The production and sales of the product in years 2, 3, 4, and 5 will be 45,000; 48,000; 40,000; and 30,000 meters respectively. The machine will be fully depreciated over 5 years using straight-line method. Cost of goods sold per unit is expected to be O.R 15. After 5 years the machine can be sold for O.R 300,000. To raise the required capital for taking this project, the company will use 40% debt (primarily bonds) and 60% common stock equity, which is also the optimum capital structure for the firm. The debt financing will be done through bonds. A similar kind of bond of the firm is currently selling in the market for O.R 950 with 6% coupon rate and O.R 1,000 face value. The maturity is in 10 years. The common stock of the firm is currently selling in the market for O.R 2.00 and has recently declared and paid dividend of O.R 0.100 per share. The dividend is expected to grow at an annual rate of 3% per year. The company is in 25% tax bracket.

Instructions: Solve manually

* What is the gross profit margin per meter of the shield cable? * Calculate the cash payback period of this investment.

*Determine the Weighted Average Cost of Capital (WACC).

*Assuming WACC is the discount rate, calculate the profitability index of the project and decide whether Oman Cables should accept the project.

*If OASIS Cables is willing to reduce its WACC by 1%, estimate the proportionate debt to equity financing.

Answer 1

Solution:

Selling price per meter of shield cable = O.R 40

Cost of goods sold per meter = O.R 15

Gross profit margin per meter - Selling price per meter - COGS per meter = O.R. 40 - O.R 15 = O.R 25 per meter

Computation of Annual Cash Inflows
Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Estimated production & Sales units (In meters)	40000	45000	48000	40000	30000
Gross profit margin per unit (In O.R)	25	25	25	25	25
Total Gross Profit Margin (In O.R) (Sales units * Gross margin per unit)	1000000	1125000	1200000	1000000	750000
Less: Tax (25% of Gross Margin)	250000	281250	300000	250000	187500
Add: Tax saving on depreciation [(2500000/5)*25%]	125000	125000	125000	125000	125000
Add: Tax saving on research and consultant cost (500000*25%)	125000
Add: Salvage value of machine after 5 years (net of tax) [(300000*(1-0.25)]					225000
Annual cash inflows (In O.R)	1000000	968750	1025000	875000	912500

Computation of cumulative cash flows
Year	Cash flows	Cumulative cash flows
1	1000000	1000000
2	968750	1968750
3	1025000	2993750
4	875000	3868750
5	912500	4781250

Initial investment = O.R. 2,500,000 + O.R 500,000 = O.R 3,000,000

Payback period will fall between 3 years to 4 years, therefore

Payback period = 3 years + (Initial investment - Cumulative cash flows at year 3) / (Cumulative cash flow at year 4 - Cumulative cash flows at year 3)

= 3 + (3000000 - 2993750) / (3868750 - 2993750) = 3.01 years

Computation of WACC:

coupon rate of bond = 6%

Face value = 1000

Current market value = 950

maturity = 10 years

let current yield on bond = r%

Therefore present value of future cash inflows at r rate = $950

Computation of present value of cash inflows at 7%

(annual interest * cumulative PV factor at 7% for 10 years) + (1000 * Pv factor at 7% at 10 period)

(60*7.0235) + (1000 * 0.5083) = O.R 929.71

Present value of cash flows at 6% will be equal to face value of bond i.e. 1000

Hence r will fall between 6% or 7%

r = 6% + (Present value of bond - Present value at 7%) / (PV at 6% - PV at 7%)

= 6% + (950 - 929.71) / (1000 - 929.71) = 6.29%

Cost of debt (kd) = 6.29% (1 - tax rate) = 6.29% (1-0.25) = 4.72%

current price of share (P0) = O.R 2

Current dividend (D0) = O.R 0.100

growth rate = 3%

Next dividend = 0.100 (1+g) = 0.100 (1+0.03) = 0.103

Cost of Equity (Ke) = D1 / P0 + g = 0.103/2 + 0.03 = 8.15%

WACC = (Kd*Wd) + (Ke*We) = (4.72*0.40) + (8.15*0.60) = 6.78%

Computation of Profitability Index
Particulars	Amount	WACC	PV Factor	Present Value
Cash Inflows:
Year 1	1000000	6.78%	0.936505	936,504.96
Year 2	968750	6.78%	0.877042	849,634.00
Year 3	1025000	6.78%	0.821354	841,887.61
Year 4	875000	6.78%	0.769202	673,051.64
Year 5	912500	6.78%	0.720361	657,329.75
Present Value of Cash Inflows (A)				3,958,407.96
Cash Outflows:
Machine Cost	2500000	6.78%	1	2,500,000.00
Research and Consultant Cost	500000	6.78%	1	500,000.00
Present Value of Cash Outflows (B)				3,000,000.00
Profitability Index (PV of cash inflows / PV of cash outflows)				1.32

Current WACC = 6.78%

Required WACC = 6.78% - 1% = 5.78%

Let Wd is the weight of debt, then weight of We = (1-Wd)

(4.72 * Wd) + (8.15 * We) = 5.78

(4.72 * Wd) + [8.15 * (1-Wd)] = 5.78

4.72Wd + 8.15 - 8.15 Wd = 5.78

3.43Wd = 2.37, Wd = 0.69

Weight of debt = 69%

Weight of Equity = 1 - 0.69 = 0.31 = 31%

Proportionate debt to equity financing = 0.69 / 0.31 = 2.22:1