Question

Broadside Sinking Sydney Limited is a company that manufactures luxury sinking yachts. The company maintains a capital cost structure of 15:45:40 for preferred equity, common equity and debt. The cost of preferred equity shares is 17%, common equity shares is 11% and debt 19%. The tax rate is 35%.

The company is approaching the end of its financial year, and the board of directors are seeking to decide on the capital budget for the forthcoming year, and the capital expenditure items the company may invest into.

The chief financial officer (CFO) has presented the board with the following list of three major capital expenditure projects for consideration with the initial outlay and projected annual after-tax cash flows for each project.

	Project A	Project M	Project U
Initial Outlay	$51,000,000.00	$90,000,000.00	$98,000,000.00
Life of Project	4 Years	6 Years	5 Years
Annual After-Tax Cash Flow
Year 1	$26,000,000.00	$21,000,000.00	$29,000,000.00
Year 2	$21,000,000.00	$22,000,000.00	$28,000,000.00
Year 3	$16,000,000.00	$28,000,000.00	$26,000,000.00
Year 4	$15,000,000.00	$27,000,000.00	$34,000,000.00
Year 5		$32,000,000.00	$41,000,000.00
Year 6		$25,000,000.00

Required:

1. Calculate the weighted average cost of capital of the company.                           [2 Marks]
2. Based on your answer in Part 1, is the IRR of Project A higher or lower than the WACC calculated in Part 1?                                                                                                [1 Mark]
3. A company director two other projects (i.e., Project B and Project C) with 4-year life spans should be considered along with Project A. Assume the initial outlay and NPV of Project B is $35,000,000 and $1,901,000 and for Project C is $45,000,000 and $3,901,000. If the company has a capital budget of $110,000,000, and Project A, B and C are independent, which project (or projects) should be accepted? (Note: Use your answer in Part 2 for the NPV of Project A).
4. Assume Broadside Sinking Sydney Limited wish to select between Project M and Project U. Both projects are mutually exclusive. Based on appropriate net present value calculation techniques, which project would be selected?

Answer 1

Capital Cost Structure
Particular	Preferred Equity	Common Equity	Debts	Total
Ratio	15	45	40	100
Cost %	17%	11%	19%
WACC	2.55	4.95	7.6	15.10%
					Amount in $'000
Particular	Years	Project A	Project M	Project U	Project B	Project C
Life of Projects		4 years	6 years	5 years
Initial Outlay		(51,000)	(90,000)	(98,000)	(53,000)	(45,000)
After Tax Inflow Annual	Year 1	26,000	21,000	29,000
	Year 2	21,000	22,000	28,000
	Year 3	16,000	28,000	26,000
	Year 4	15,000	27,000	34,000
	Year 5		32,000	41,000
	Year 6		25,000
NPV					1,901	3,901
IRR		22.00%	3.33%	7.32%
b) IRR for Project A is higher than the WACC
c) As the Capital budget of the Company is $110,000,000
	Thus Project A and Project C should be chosen
	As Project A has higher IRR of 22% and Project C has higher NPV of $ 3901000.
d) Out of Project M & Project U , Project U will be chosen on the basis of higher IRR values.