Question

Suppose ABC firm is considering an investment that would extend the life of one of its facilities for 5 years. The project would require upfront costs of $8M plus $40M investment in equipment. The equipment will be obsolete in 9 years and will be depreciated via straight-line over that period (Assume that the equipment can't be sold). During the next 5 years, ABC expects annual sales of 63 M per year from this facility. Material costs and operating expenses are expected to total 38M and 7.8M, respectively, per year. ABC expects no net working capital requirements for the project, and it pays a tax rate of 36%. ABC has 77% of Equity and the remaining is in Debt. If the Cost of Equity and Debt are 15% and 6% respectively, should they take the project?

What are the ?

·     WACC

·     Incremental FCF at 0

·     Incremental FCF from year 1 to year 5

·     NPV

Answer 1

WACC = weight of debt*cost of debt*(1-tax rate) + weight of equity*cost of equity

weight of equity is 77%. so, weight of debt = 100% - 77% = 23%. total weight of capital structure is always 100%.

WACC = 0.23*6%*(1-0.36) + 0.77*15% = 0.23*6%*0.64 + 11.55% = 0.8832% + 11.55% = 12.43%

NPV is the difference between present value of cash flows and initial investment.

present value of cash flows = Year 1 cash flow/(1+WACC) + Year 2 cash flow/(1+WACC)² + Year 3 cash flow/(1+WACC)³ ... + Year 5 cash flow/(1+WACC)⁵

Initial investment = upfront costs + investment in equipment = $8,000,000 + $40,000,000 = $48,000,000

	Years	0	1	2	3	4	5
	Initial investment	-$48,000,000	0	0	0	0	0
	Annual sales	$0	$63,000,000	$63,000,000	$63,000,000	$63,000,000	$63,000,000
Less:	Material costs	$0	$38,000,000	$38,000,000	$38,000,000	$38,000,000	$38,000,000
Less:	Operating expenses	$0	$7,800,000	$7,800,000	$7,800,000	$7,800,000	$7,800,000
Less:	Depreciation	$0	$5,333,333	$5,333,333	$5,333,333	$5,333,333	$5,333,333
	Pre-tax cash flow	$0	$11,866,667	$11,866,667	$11,866,667	$11,866,667	$11,866,667
Less:	Taxes @36%	$0	$4,272,000	$4,272,000	$4,272,000	$4,272,000	$4,272,000
	After-tax cash flow	$0	$7,594,667	$7,594,667	$7,594,667	$7,594,667	$7,594,667
Add back:	Depreciation	$0	$5,333,333	$5,333,333	$5,333,333	$5,333,333	$5,333,333
	Incremental FCF	-$48,000,000	$12,928,000	$12,928,000	$12,928,000	$12,928,000	$12,928,000
	NPV	-$1,889,644.19

Calculation