Question

QWY company is looking to build a manufacturing plant overseas. Project = 5yrs The cost of the land for this project is £6,500,000. The land can be sold for £4,500,000 in five years’ time, irrespective of what is built on it (ignore taxes). The manufacturing plant will cost £15,000,000. The company uses straight line method of depreciation and predicts to sell the plant for £5,000,000 (ignore taxes) at the end of the project. The expectation from the project is to sell 12,000 units per year at a selling price of £9,500 per unit. The variable production costs are £8,500 per unit in each of the five years. The company will incur £1,000,000 in fixed costs in each of the five years. You are given the following market data on the firm’s securities:

Debt – 150,000 bonds outstanding, 7% coupon, paid annually; 15 years to maturity; each bond has £100 par value and currently sells at 92% of par.

Ordinary shares – 300,000 shares outstanding, market price £75 per share; the beta is 1.3

Preference shares – 20,000 shares outstanding with 5% dividend, par value £100, market price £70 per share The market risk premium is 8%, and the risk-free rate is 5%. The management foresees that the new project is riskier than a typical project they undertake. Therefore, an adjustment factor of 1.5% to the cost of capital needs to be done to account for the increased risk. The company’s tax rate is 30%.

You are required to:

i) Calculate the project’s initial cash out flow at time t = 0.

ii) Calculate the market value of debt, ordinary shares and preference shares, as well as for the company as a whole.

iii) Calculate the appropriate cost of capital to use when evaluating the project. (round it up or down to the nearest whole percentage)

iv) What is the project’s annual operating cash flow? v) What is the NPV for the project?

Answer 1

i) Initial cash flow at t=0

Land cost	£65,00,000
Plant cost	£1,50,00,000
Total initial cost	£2,15,00,000

ii) Market value of debt = 150000* (100*92%)

= £1,38,00,000

Market value of equity = 300000 * 75

= £2,25,00,000

Market value of prefernce = 20000 * 70

= £14,00,000

Total company value = £1,38,00,000 + £2,25,00,000 + £14,00,000

= £3,77,00,000

iii) Yield to maturity = (C + (F-P)/n) / ((F+P)/2)

=  (7 + (100-92)/15) / ((100+92)/2)

= 7.84%

After tax cost of debt = 7.84% * (1-40%)

= 4.71%

Cost of equity = risk free rate+ beta* market risk premium

= 5% + 1.3*8%

= 15.4%

Cost of preference = dividend / price

= 5 / 70

= 7.14%

WACC for the company

Capital	Cost of capital	Market value	Weights	Weighted cost of capital
Debt	0.0471	£1,38,00,000	0.3660	0.0172
Equity	0.1540	£2,25,00,000	0.5968	0.0919
Preference	0.0714	£14,00,000	0.0371	0.0027
		£3,77,00,000		11.18%

Cost of capital for the project = 11.18% + 1.5%

= 13%

iv) Projects annal operating cash flows

	0	1	2	3	4	5
Selling units		12,000	12,000	12,000	12,000	12,000
selling price		£9,500	£9,500	£9,500	£9,500	£9,500
Sales revenue		£11,40,00,000	£11,40,00,000	£11,40,00,000	£11,40,00,000	£11,40,00,000
Variable cost per unit		£8,500	£8,500	£8,500	£8,500	£8,500
Variable cost		£10,20,00,000	£10,20,00,000	£10,20,00,000	£10,20,00,000	£10,20,00,000
Fixed costs		£10,00,000	£10,00,000	£10,00,000	£10,00,000	£10,00,000
Depreciation		£30,00,000	£30,00,000	£30,00,000	£30,00,000	£30,00,000
Operating income		£80,00,000	£80,00,000	£80,00,000	£80,00,000	£80,00,000
Income tax		£24,00,000	£24,00,000	£24,00,000	£24,00,000	£24,00,000
Net income		£56,00,000	£56,00,000	£56,00,000	£56,00,000	£56,00,000
Operating cash flows		£86,00,000	£86,00,000	£86,00,000	£86,00,000	£86,00,000

NPV of the project

	0	1	2	3	4	5
Operating cash flows		£86,00,000	£86,00,000	£86,00,000	£86,00,000	£86,00,000
Initial investment	-£2,15,00,000
Terminal cah flows:
Sale of land						£45,00,000
Sale of plant						£50,00,000
Net cash flows	-£2,15,00,000	£86,00,000	£86,00,000	£86,00,000	£86,00,000	£1,81,00,000
Cost of capital@13%	1	£0.885	£0.783	£0.693	£0.613	£0.543
PV of cash flows	-£2,15,00,000	£76,10,619	£67,35,061	£59,60,231	£52,74,541	£98,23,955
NPV	£1,39,04,408