Question

• Microsoft is evaluating a potential investment in a new datacenter facility located in Europe. The initial capital investment in this facility is $10 million with an expected useful life of 5 years.
• The datacenter is to be depreciated to the book value of $0 over the 5 years and it is expected to be sold for $2 million at the end of project.
• Microsoft has already is commissioned a consultant firm in order to perform a technical due diligence of the facility. The service fee paid amount is $500000.
• The gross revenue the Microsoft is planning to generate with the new facility will be $2.8 million per year for the 5 year (starting of the end of year1).
• The annual variable cost for the datacenter will be 25% of gross revenue for every year.
• The project requires $500000 of working capital immediately but it will not require any other working capital investment during its life. The working capital will be recovered in the last year of the project.
• The corporate rate tax is 30% and Microsoft has a weighted average cost of capital of 15%.
• Microsoft is planning to finance this project using the higher proportion of debt than the one used to finance the company as whole.

1. Calculate free cash flow for every year and net present value (NPV). Show calculation Should Microsoft under take this project based on your analysis? Explain why or why not?
2. The Microsoft Company will be financing the project using higher proportion of debt than the one used to finance the company as a whole. What risk is Microsoft incurring by using the company’s WACC as a discount rate? What would happen to WACC and NPV of the project in the case Microsoft would be using the appropriate discount rate?
3. Under what condition WACC can be used as a discount rate for the cash flow of a specific project?

Answer 1

Given :
Capital Investment	$        10,000,000
Useful life in years	5
SL Depreciation per year	2,000,000
Income Tax rate	30%
Salvage value	$          2,000,000
Tax on Capital gain on salvage value	600,000
Annual Tax shield on Depreciation=$2M*30%=	600,000
We are ignoring the cost of technical due
diligence for capital project evaluation as it
is a sunk cost.
WACC of Capital	15%
Additional investment in WC	$             500,000
After Tax EBIT per year
Annual Revenue	$          2,800,000
Annual variable cost @25%	$             700,000
Earning Before Tax	$          2,100,000
Tax 30%	$             630,000
After Tax Income per year	$          1,470,000

	NPV Calculation
	Details	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
	Initial Investment
	Capital Investment	$      (10,000,000)
	Investment in WC	$            (500,000)
a	Total Initial Outlay	$      (10,500,000)
	Cash flow from Operations :
	After Tax Operating income		$         1,470,000	$           1,470,000	$      1,470,000	$        1,470,000	$       1,470,000
	Add: Depreciation Tax Shield		$            600,000	$              600,000	$         600,000	$            600,000	$          600,000
b	Total Cash flow from oeprations		$         2,070,000	$           2,070,000	$      2,070,000	$        2,070,000	$       2,070,000
	Terminal Cash flow
	Salvage value of Investment						$       2,000,000
	Less Tax on Capital gain on salvage						$         (600,000)
	Return of NWC						$          500,000
c	Total Terminal Cash Flow						1,900,000
d	Free Cash Flow from Project=a+b+c=	$      (10,500,000)	$         2,070,000	$           2,070,000	$      2,070,000	$        2,070,000	$       3,970,000
e	PV factor @15%=1/1.15^n=	1.0000	0.8696	0.7561	0.6575	0.5718	0.4972
f	PV of Free Cash flows =d*e	$      (10,500,000)	$         1,800,072	$           1,565,127	$      1,361,025	$        1,183,626	$       1,973,884
g	NPV=Sum of PV of Free Cash flows	$        (2,616,266)
	Ans .
	As the NPV of the Project is negative , Microsoft should not accept the project.

Ans 2.
As Microsoft is planning to use a higher proportion of Debt than the usual capital structure for financing this project, the WACC of the
capital to be used for funding the project will be different from 15%. Use of higher debt generally reduces the WACC unless the high geraing
increases the cost of equity more than before. The WACC of the fund to be used for this project will also depend on the specific business risk
of the project. Microsoft will face the risk that if the effective WACC of the Project is lower than 15% as used in evaluation, then it may
wrongly turn the NPV negative, when the NPV should be positive due due a lower WACC. So Microsoft bears the risk of rejecting a profitable
investment if it uses a wrong WACC as discount factor.

Ans 3.
WACC can be used as the discount factor for the cash flows of a project when the marginal cost of the capital invested for the project
consdiers the project specific business risks and capital structure related financial risks and the risk adjusted cost of capital absorbs all
risks pertaining to the specific project. I such a case the WACC will be useful for discounting the Cash flows of the project.