Question

Investment in new machinery $10,000,000 Useful life of the machinery 5 years Depreciated using straight line depreciation to zero salvage value over the useful life of machinery

Expected life of the project 4 years Expected incremental annual sales in the next 4 years $12,500,000 Cost of goods sold 60% of sales Fixed Operating Expenses per year $500,000 Estimated selling price at the end of 4 years $1,750,000 Working capital needs to support sales of $12,500,000 $3,000,000 Working capital will be provided at the beginning of the project and recouped at the end of project

Tax rate 40% Beta of HMM 1.5 Risk-free rate 3% Market risk premium 6% After tax cost of debt 6% Target debt ratio 40%

(a) HMM is looking at investment in the new machine. In order to evaluate the project, estimate the relevant cash flows and calculate the following:

(i) Weighted average cost of capital


(ii) Initial Investment (Investment in net working capital of $3,000,000 is at the start of the project and recovered at the end of the project)

(iii) Annual cash flows


(iv) Terminal Cash flows


(v) Net present value


(b) Recommend whether the project should be undertaken.

Answer 1

I ) WACC:-

Cost of equity= Rf + Beta * market risk premium

= 3% + 1.5 * 6%

= 3% + 9%

Cost of equity =12%

WACC = after tax cost of debt * Weight of debt + Cost of equity * weight of equity

= 6% * 0.40 + 12% * 0.60

WACC = 2.4% + 7.2%

WACC = 9.6%

ii) Calculation of the initial investment :-

Initial investment = cost of equipment + working capital investment

= $ 10,000,000 + 3,000,000

Initial investment = $ 13,000,000

Note :-Recovery of working capital we included in Terminal cash inflows

iii) Annual cash inflows:-

Depreciation = $ 10,000,000 /5 = $ 2,000,000 per year.

Here Target debt ratio 40%

Debt amount in purchase of machinery = 4,000,000

Before tax cost of debt = 6% / ( 1 - 0.40) = 10%

Interest amount = 4,000,000 * 10% = $ 400,000 per year

particulars	1	2	3	4
Sales	12,500,000	12,500,000	12,500,000	12,500,000
Less- cost of goods sold	7,500,000	7,500,000	7,500,000	7,500,000
Fixed operating cost	500,000	500,000	500,000	500,000
Less- Depreciation	2,000,000	2,000,000	2,000,000	2,000,000
EBIT	2,500,000	2,500,000	2,500,000	2,500,000
Less- Interest	400,000	400,000	400,000	400,000
EBT	2,100,000	2,100,000	2,100,000	2,100,000
Less- Tax@40%	840,000	840,000	840,000	840,000
Profit after tax	1,260,000	1,260,000	1,260,000	1,260,000
Add- Depreciation	2,000,000	2,000,000	2,000,000	2,000,000
Annual operating cash inflows	3,260,000	3,260,000	3,260,000	3,260,000

iv) Terminal cash inflows :-

Terminal cash inflows = Proceeds from sale equipment after tax + Recovery of working capital

After tax proceeds from the sale of Equipment :-

Book value of equipment at end of 4th year = 2,000,000

Sale proceeds from the machinery = 1,750,000

Gain or (loss) on sale of equipment = ( 250,000)

Tax shield On loss of sale of equipment = 250,000 * 40% = $ 100,000

After tax proceeds from sale of equipment = 1,750,000 + 100,000 =$ 1,850,000

Terminal cash inflows = Proceeds from sale equipment after tax + Recovery of working capital

Terminal cash inflows = $ 1,850,000 + 3,000,000 = $ 4,850,000

V) NPV :-

NPV = present value of cash inflows - initial investment

Present value of cash inflows :-

Years	Operating cash flows	Terminal cash inflows	Total cash inflows	PV [email protected]%	PV of CF
1	3,260,000		3,260,000	0.912408759	2,974,452.55474
2	3,260,000		3,260,000	0.832489744	2,713,916.56455
3	3,260,000		3,260,000	0.759570934	2,476,201.24503
4	3,260,000	4,850,000	8,110,000	0.693039173	5,620,547.69635
Present value of cash inflows	13,785,118.06067

NPV = Present value of cash inflows - initial investment

=13,785,118.06067 - 13,000,000

NPV = $ 785,118.06067

b) Here NPV is positive. so Company should accept the project.