Question

Wesson United is considering updating its equipment to meet increased demand for its product. The cost of the equipment update is $380,000, plus $20,000 in installation costs. Due to the increased sales, there will be an additional $40,000 working capital needed. The company will depreciate the equipment to zero over its 5 year life using a straight-line depreciation method. Additional sales revenue from the modifications should amount of $220,000 per year, and additional operating expenses and other costs (excluding depreciation) will amount to 35% of the additional sales. The company has an ordinary tax rate of 30%. Wesson’s market value balance sheet shows a capital structure of 60% debt and 40% ordinary shares. The firm expects to maintain this debt equity mix. Its outstanding bonds offer investors a 5.4% yield to maturity. The risk-free rate currently equals 5%, and the expected risk premium on the market portfolio equals 6%. Wesson’s ordinary equity beta is 1.5.

a) What is Wesson company’s required return on equity?                        

b) What opportunity cost of capital should Wesson Company use to evaluate the above project?

c) What incremental operating cash flows will result if Wesson updates its equipment?

i) at time zero

ii) each of years 1-4 of the project

iii) at the end of the project (year 5)

d) What is the value (NPV) of this project?

e) Should Wesson update the equipment? Why or why not?

Answer 1

a]	Cost of equity per CAPM = Risk free rate+Beta*Market risk premium = 5%+1.5*6% =	14.00%
b]	After tax cost of debt = 5.4%*(1-30%) =	3.78%
	WACC = 14%*40%+3.78%*60% =	7.87%
	Opportunity cost for evaluation = WACC = 7.87%
c]
i]	Cost of equipment plus installation = 380000+20000 =	$    -4,00,000
	Additional working capital	$       -40,000
	Cash flow at t0	$    -4,40,000
ii]	Additional sales revenue	$     2,20,000
	Operating costs and other expenses [220000*35%]	$ 77,000
	Depreciation [400000/5]	$ 80,000
	Incremental NOI	$ 63,000
	Tax at 30%	$ 18,900
	Incremental NOPAT	$ 44,100
	Add: Depreciation	$ 80,000
	OCF [Years 1 to 4]	$     1,24,100
iii]	Annual OCF [as at ii]	$     1,24,100
	Recapture of working capital	$ 40,000
	Cash flows at t5	$     1,64,100
d]	PV of OCF [t1 to t4] = 124100*(1.0787^4-1)/(0.0787*1.0787^4) =	$     4,12,227
	PV of cash flow at t5 = 164100/1.0787^5 =	$     1,12,358
	PV of cash inflows	$     5,24,585
	Less: Initial investment	$     4,44,000
	NPV	$ 80,585
e]	As the NPV is positive, Wesson should update the equipment.