Question

ABC, Inc is considering launching a new product which incurred $2.5 million in Research and Development expenses over the last year. The company will spend $1.8 million to acquire the equipment necessary for the manufacture of the new product. The equipment will last for 15 years and have a salvage value of $35,000. It will be depreciated to zero over 10 years using straight line depreciation. The company will also have an increase of $250,000 in accounts receivable and a decrease of $75,000 in accounts payable. The company anticipates to produce 100,000 units every year for the next 15 years and sell the units for $4 per unit. The variable costs are $0.25 per unit and the annual fixed costs are projected to be $10,000 per year. The company has a target capital structure of 40% debt and 60% equity. The company’s outstanding bonds have a yield to maturity of 5.5% and the company’s tax rate is 30%. The company has a beta of 1.4, the risk free rate is 2% and the market risk premium is 6%. Answer the questions below and show all the formulae you used and all the calculations. Each question is worth 10 points and the entire assignment is worth 100 points

1) What is the project’s cash flow at time 0?

2) What is the after tax operating cash flow in years 1 through 10?

3) What is the after tax operating cash flow in years 11 through 14?

4) What is the after tax cash flow in year 15?

5) What is the company’s cost of equity?

6) What is the company’s WACC?

7) What is the NPV of the project?

8) What is the IRR of the project?

9) What is the profitability index?

10) Should the company launch the new product?

Answer 1

ABC, Inc has already spent $2.5 million on research and development costs and should therefore be treated as a sunk cost. This means that the cost should be taken into account for decision making purposes for the new product.

Part 1:

At time 0, the project's cash flow will be negative $1.8 million spent on equipment.

Part 2:

Operating cash flow after tax in years 1 through 10 will be $1,319,500.

The calculation on Excel is as follows:

The formulas used are as follows:

Part 3:

Operating cash flow after tax in years 11 through 14 will be $1,022,000.

Part 4:

From the above calculation, Operating cash flow after tax in year 15 will be $255,500 plus the working capital changes of negative $175,000, So, cash flow after tax = $255,500-$175,000= $80,500.

Part 5:

Cost of equity can be calculated using Capital Asset Pricing model(CAPM).

Cost of equity= Risk free rate+(Beta*Market Risk Premium)

From the given information, we can calculate cost of equity as follows:

The formulas used are as follows:

Part 6:

Weighted Average cost of capital = Cost of debt*Weightage of debt*(1-tax rate)+cost of equity*Weightage of equity

The calculation is as follows: