Question

GEL has 10 million shares originally issued at $100 and 2 million 5% semi-annual bonds issued
at face value of $1000 outstanding. The bonds have 15 years to maturity and are currently
selling at par. The common stock currently trades at $300 per share.
The current beta of the company is estimated to be 1.5. The expected return on the market is
10.5 per cent. The relevant T-Bills are yielding 3 per cent. The applicable corporate tax rate is
30 per cent.
GEL is currently in the process of applying for a tender offer for one of the newly discovered
mines for Gems and other precious stones. The acronym for this project is GPS. GPS is a part
of the expansion and diversification strategy of GEL.
The geoscientists at GEL spent $500,000 to gather particulars about the mine. Their report
forms the basis of the analysis. The acquisition cost is estimated to be $73 million. The setup
required for extraction and refining of these stones is estimated to be $7 million. GEL also
requires replacing some of its existing excavators. The new excavators will cost $3 million,
and the old ones, which are already fully depreciated, shall be sold at $2 million. The additional
working capital required would be $1 million.
The estimated life of the mine is five years. At the end of 5 years, the mine along with the
existing setup and excavators shall be sold for $25 million. The depreciation on the mine, setup
and excavators is to be charged on straight line method, and the values are to be written down
to nil during this period.
The expected sales revenue from finished stones is $30 million each year. The variable
operating cost is 30% of the sales revenue. GEL intends to use management personnel,
employees and labour from another project. Consequently, the progress of the other project
gets affected. The estimated cash flow impact of undertaking GPS to the other project is $1
million per year. The finished products from GPS shall be stored in the existing secured
warehouse already costing $500,000 a year to GEL as fixed cost.
Finally, the capital structure and risk for the investments in GPS remain the same as for GEL.
Required:
(a) Evaluate the project and advise if GEL should invest in this project. Show all
working/detailed steps that lead to the final answers.
(b) Suppose GPS is financed only by equity. In this case, what discount rate should GEL use
to evaluate GPS? Will that revise the decision made in part (a)? Show all workings.

Answer 1

WACC calculations

Cost of equity, ke, as per CAPPM

ke=RFR+(Beta*(Expected return-RFR))

ie.3%+*1.5*(10.5%-3%))=

14.25%

After-tax cost of debt, kd

As the bonds are currenetly trading at par,

the yield or YTM must be equal to the coupon rate

so, the efffective before-tax annual yield =(1+2.5%)^2-1=

5.0625%

The after-tax yield on the bond=

Before-tax yield*(1-Tax rate)

ie. 5.0625%*(1-30%)=

3.54%

Now, the WACC is

Capital	Market value--$ mlns	Wt. to total	Cost	Wt. * Cost
Equity(10*300)	3000	60.00%	14.25%	8.55%
Bonds(2*1000)	2000	40.00%	3.54%	1.42%
	5000	100.00%	WACC=	9.97%

.   Fig. in mlns.
Year	0	1	2	3	4	5
1.Acquisition cost	-73
2.Set up costs	-7
3.Cost of new excavators	-3
4.After-tax sale value old excavators(2*(1-30%))	1.4
5.NWC reqd. & recovered	-1					1
6.After-tax sale value of mine, set-up & Excav.(25*(1-30%))						17.5
Operating cash flows:
7.Sales revenues		30	30	30	30	30
8.Variable opg. Costs (sales *30%)		-9	-9	-9	-9	-9
9.Cannibalisation effect		-1	-1	-1	-1	-1
10.Depn.(73+7+3)/5		-16.6	-16.6	-16.6	-16.6	-16.6
11.EBIT (Sum 7 to 10)		3.4	3.4	3.4	3.4	3.4
12.Tax at 30%(11*30%)		-1.02	-1.02	-1.02	-1.02	-1.02
13.EAT/NOPAT(11+12)		2.38	2.38	2.38	2.38	2.38
14.Add Back: Depn. (row 10)		16.6	16.6	16.6	16.6	16.6
15.Opg. Cash flow(13+14)		18.98	18.98	18.98	18.98	18.98
16.Total annual FCFs(1+2+3+4+5+6+15)	-82.6	18.98	18.98	18.98	18.98	37.48
17.PV F at 9.97%(1/1.0997^Yr.n)	1	0.90934	0.82690	0.75193	0.68376	0.62177
18.PV at 9.97 %(16*17)	-82.6	17.25925	15.69451	14.27163	12.97775	23.30389
19.NPV at 9.97%(sum of row 18)	0.90703	ie.$90703
	mlns.
IT IS ADVISABLE TO INVEST, as NPV is POSITIVE at the WACC of 9.97%
(b)If GPS is financed only by equity, discount rate GEL should use is the cost of equity, 14.25%
It wil REVISE the decision---not recommended --as cost of equity, 14.25% is greater than the WACC, 9.97% ---discounting the FCFs, by which , will decrease the NPV. ---as shown below:
Discounting the above FCFs at 14.25%
16.Total annual FCFs(1+2+3+4+5+6+15)	-82.6	18.98	18.98	18.98	18.98	37.48
17. PV F at 14.25%(1/1.1425^Yr.n)	1	0.87527	0.7661	0.67055	0.58691	0.51371
18. PV at 14.25%(16*17)	-82.6	16.61269	14.54065	12.72705	11.13965	19.25389
19.NPV at 14.25%(sum of row 18)	-8.32608	mlns.
The NPV is NEGATIVE at 14.25% discount rate

Also the IRR of the FCFs (row 16) is 10.36%

Any discount rate /cost of capital applied --above this will result in negative NPV & hence the project will need to rejected.