Question

2.1. Advanced Heating Systems Limited (AHSL) is a large publicly listed company and is the market leader in the heat pump manufacturing industry. The company is planning a six-year project setting up a manufacturing plant overseas to produce a new line of residential heat pumps. The company bought a piece of land four years ago for $ 9 million in anticipation of using it for its proposed manufacturing plant. If the company sold the land today, it would receive $ 10.50 million after taxes. In six years the land can be sold for $8 million after taxes and reclamation costs. AHSL wants to build a new manufacturing plant on this land. The plant will cost $280 million to build. The following is the AHSL’s current market data.

Debt	$150,000,000, 6.75% coupon bonds outstanding with 20 years to maturity redeemable at par, selling for 95 percent of par; the bonds have a $1000 par value each and make semi-annual coupon payments.
Equity	12,500,000 ordinary shares, selling for $40 per share
Preference shares	10,000,000 preference shares (par value $ 10 per share) with 6.5% dividends (after taxes), selling for $25 per share

The following information is relevant:

Advanced Heating Systems Limited’s tax rate is 28%

The company had been consistently paying dividends to its ordinary shareholders. Dividends paid during the past five years were as follows:

Year (-4) ($)	Year (-3) ($)	Year (-2) ($)	Year (-1) ($)	Year (0) ($)
5.6	5.9	6.2	6.5	7.0

The project requires $ 10.25 million in initial net working capital investment in year₀ to become operational.

Work all solutions to the nearest two decimals.

Required:

Calculate the project’s initial, (year₀) cash flows, taking into account all side effects.

Compute the weighted average cost of capital (WACC) of Advanced Heating Systems Limited. Show all workings and state precisely the assumptions underlying your calculations.

Using the WACC calculated in part (2) and assuming the following, compute the project’s Payback Period, Net Present Value (NPV), Internal Rate of Return (IRR) and the Profitability Index (PI).

The manufacturing plant has a ten-year tax life, and AHSL uses Diminishing value method of depreciation for the plant at 20 % per annum. At the end of the project, (i.e., at the end of year 6), the plant can be scrapped for $ 21 million.

The project will incur $185 million per annum in fixed costs.

AHSL is expected to manufacture 320,000 residential heat pumps per year in each of the years, and the estimated selling price is $ 1,850 per heat pump.

The variable production costs are $ 850 per heat pump.

At the end of year 6, the company will sell the land.

2.2. Is it acceptable to use a firm’s risk-adjusted cost of capital to assess its investments? Explain why or why not.

Answer 1