Question

Singer inc is about to start a 4 year project. A new plant will be built. The plant will require an amount of 40 million to acquire new fixed assets that will be depreciated straight-line through the life of the project. The company also possesses a building that it bought for 5 million and has a net book value of 0. Todays market value for the building is 4.1 million while it can be rented for 220,000 yearly. The company wants to situate its new plant in this building.

The following are todays market data for singer (before the project starts).

- debt: 240,000,000. Interest rate 7,5. Debt is constant

-Common stocks: 9,500,000 shares outstanding. Stock price 63.

-The levered equity beta i 1.2.

-Market 8% expected market risk premium.

-risk free rate: 5%

JP Simon Bank charges singer 1040000 as an underwriter fee on new common stock issues. Singer will raise the funds needed for the project by only issuing stock. The tax rate is 35%. The project will be managed in total separation for the others operations of the firm.

A) Calculate the new projects initial (time 0) cashflow

B) The new project has a risk profile comparable with the riskiness of its assets in place. What is the appropriate opportunity cost of capital for the project=

The Company will incur 4,000,000 in SG&A. The plant will manufacture 20,000 wigets p/year and sell them for 6,900 each. The unit production is 5,400.

C) What is the annual after-tax cashflow from the new project at the end of each of the four years

D) Assuming that the depreciation tax shield is as risky as the company's debt. what is the projects NPV?

Answer 1

• a. As it is given that

  the company wants to situate its new plant in this building,

  the market value $ 4.1 mln. is irrelevant to the project decision

  Only the loss of after-tax annual rental income of 220,000 counts while calculting relevant cash flows of the project--- t=0 CF= $ 40 mlns.

  b & d.Appropriate opportunity cost of capital / WACC

  After-tax cost of debt=7.5%*(1-35%)=

  4.875%

  Cost of equity

  Given that

  The debt amount is kept constant.

  so, we will have the funding of $ 40 mln..fully by equity

  whose issue costs are 1.040 mln.

  ie. 1.040/40=

  2.60%

  Additional cost of equity

  Cost of equity as per CAPM,

  ke=RFR+(Beta*MRP)

  ie. 5%+(1.2*8%)=

  14.60%

  PLUs the above issue costs,

  14.60%+2.6%=

  17.20%

  so, now the WACC=

  (Wtd*kd)+Wt.e*ke)

  MV of debt= $ 240 mln.

  MV of Equity=9.5 mln.*63= $ 598.5 mlns+ new 40 mlns.=638.5 mlns.

  So, WACC= (240/(240+638.5)*4.875%)+(638.5/(240+638.75)*17.20%)=

  13.83%

  so, the Appropriate opportunity cost of capital. Will be the cost of equity 17.20%

  but , given in d. that the

  the depreciation tax shield is as risky as the company's debt

  WACC , 13.83% will be the correct rate to discount cash flows