Question

XYZ Corporation has traditionally been a ski producer. However, due to several years with little snow, they are exploring the opportunity to start producing umbrellas as they can use some of the waste material from the ski production to make umbrellas. To start producing umbrellas, they have to buy machinery for $1 million. The machine will have a life of 10 years and will be depreciated linearly over 10 years. At the end of the 10th year, they expect to sell the machine for $50 000.  They can use one of their current buildings as a factory, as it has been idle due to lower demand for their current product line. The market value of the building is estimated to be$500 000. They expect sales to be $200 000 the first year, $300 000 the second year and then $700 000 for year 3 to 10. The operating costs are 40% of sales. In addition, there are admin expenses of $100 000 each year. The target debt to equity ratio 0.5 and their cost of debt is 4%. The equity beta of XYZ is 0.7 and their current debt to equity ratio is 0.5. They believe that the project carries the same market risk as their current business. The expected return on the market is 7% and the risk-free rate is 2%. The tax rate is 30%.

Question: What are the cash flows from selling the Machine at the end of year 10?

Question: What WACC would you use for the umbrella project?

Question: Calculate the cash flow for year 4

Answer 1

A. The cash flows from selling the machine at the end of the 10th year will be the money they expect to sell the machine for which is $50000. As we will already take salvage value in consideration when we calculate depreciation, the book value will also be equal to 50000 and hence there will be no tax liability.

B. WACC will be based on the target d/e ration which is given as 0.5

i.e. equity= 67% and debt= 33%

cost of equity will be computed using the capm formula

Ke = risk free rate+ b(return on market - risk free rate)

Ke = 2 + 0.7( 7 - 2)

Ke = 5.5%

Wacc = cost of debt x precentage of debt x (1- tax rate) + (cost of equity x percentage of equity)

Wacc = 4 x 0.33 x 0.7 + ( 5.5 x 0.67)

wacc = 4.61%

Thats why the wacc which will be used to discount the project will be 4.61%

3

	P & L of 4th year
	Sales	700000
	variable cost	-280000
	(40% of the sales )
	gross profit	420000
	fixed cost	-100000
	profit before depreicaition	320000
	Depricaition	-95000
	Profit before interest and taxes	225000
	Interest	-13320
	Profit before taxes	211680
	Taxes	-63504
	Net profit	148176
	Cash flow = Net profit + non cash expenses (depriciation)
	Cash flow =	148176 + 95000
		243176

Notes - As its not mentioned the building would be sold if not used for this operation and it was idel anyways, we wont consider the amount of building in any calculations'

working note - Depreciation = (cost of machine - salvage value ) / no of years operational

= (1000000 - 50000) / 10

= 95000