In: Finance
Galaxy Industries Limited is a large publicly listed company and
is the market leader in vacuum cleaner
manufacturing in New Zealand. The company is looking to set up a
manufacturing plant overseas to produce a
new line of commercial vacuum cleaners. This will be a six-year
project. The company bought a piece of land
four years ago for $ 8 million in anticipation of using it for its
proposed manufacturing plant. If the company
sold the land today, it would receive $ 10.25 million after taxes.
In six years the land can be sold for $11.5 million
after taxes and reclamation costs. Galaxy Industries Ltd wants to
build a new manufacturing plant on this land.
The plant will cost $295 million to build.
The following market data on Galaxy Industries Ltd are current:
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15,000,000ordinary shares, selling for $55 per share | ||
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The following information is relevant:
• Galaxy Industries Ltd’s tax rate is 28%.
The project requires $ 8.5 million in initial net working
capital in year 0 to become operational.
• The company had been paying dividends on its ordinary shares
consistently. Dividends paid
during the past five years is as follows
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4.6 | 4.8 | 5.2 | 5.3 |
5.9 |
The manufacturing plant has a ten-year tax life, and the company uses Diminishing value method of depreciation at 25% per annum for the Plant.
At the end of Year 6, the Plant can be scrapped for $ 52 million. The company estimations show that 280,000 vacuums are manufactured and sold per year (Years 1-6) and selling price per unit in year one is $2,100, but the price will increase by 2% per year. Similarly, the variable costs per unit are expected to be $900 for year one but will increase by 2.5% per year in the subsequent periods. The project will incur $220 million per annum in fixed costs (fixed costs includes coupon payments to bondholders). At the end of year 6, the company will sell the land.
Required:
1. Calculate the project’s initial, (time 0) cash flows.
2. Compute the weighted average cost of capital (WACC) of Galaxy
Industries Ltd. Show all workings and
state clearly any assumptions underlying your computations.
3. Using the WACC computed in part (2) above and assuming the
following, compute the project’s Net
Present Value (NPV), Internal Rate of Return (IRR) and the
Profitability Index (PI).
Note: Work all solutions to the nearest two decimals, show
depreciation table, calculate gain/loss on the sale of Plant, and
Land. Record tax effects in the income statement.
Fig.in mlns.Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
1.After-tax sale value of land | -10250000 | 11500000 | |||||
2.Cost to build plant | -295000000 | ||||||
3.NWC reqd. & recovered | -8500000 | 8500000 | |||||
4.ATCFon plant sal.(Ref.dep. wkgs.) | 52141025 | ||||||
Operating cash flows: | |||||||
5.No.of units mfd.& sold | 280000 | 280000 | 280000 | 280000 | 280000 | 280000 | |
6.Price/unit | 2100 | 2142 | 2184.84 | 2228.54 | 2273.11 | 2318.57 | |
7.Sales $(5*6) | 588000000 | 599760000 | 611755200 | 623990304 | 636470110.1 | 649199512.3 | |
8.Variable cost/unit | 900 | 922.5 | 945.5625 | 969.20156 | 993.4316016 | 1018.267392 | |
9.Total Var.costs(5*8) | -252000000 | -258300000 | -264757500 | -271376438 | -278160848 | -285114870 | |
10.Fixed costs | -220000000 | -220000000 | -220000000 | -220000000 | -220000000 | -220000000 | |
11.Depn.(Ref. wkgs.) | -73750000 | -55312500 | -41484375 | -31113281 | -23334960.9 | -17501220.7 | |
12. EBT(7+9+10+11) | 42250000 | 66147500 | 85513325 | 101500585 | 114974300.7 | 126583421.9 | |
13. Tax at 28%(12*28%) | -11830000 | -18521300 | -23943731 | -28420164 | -32192804.2 | -35443358.1 | |
14. EAT(12+13) | 30420000 | 47626200 | 61569594 | 73080421 | 82781496.51 | 91140063.79 | |
15. Add back:Depn.(row 11) | 73750000 | 55312500 | 41484375 | 31113281 | 23334960.94 | 17501220.7 | |
16. Opg. Cash flows(14+15) | 104170000 | 102938700 | 103053969 | 104193703 | 106116457.4 | 108641284.5 | |
17.Total Annual FCFs(1+2+3+4+16) | -313750000 | 104170000 | 102938700 | 103053969 | 104193703 | 106116457.4 | 180782309.5 |
18.PV F at 8.12%(1/1.0812^yr.n) | 1 | 0.92490 | 0.85544 | 0.79119 | 0.73177 | 0.67681 | 0.62598 |
19.PV at 8.12%(17*18) | -313750000 | 96346651.9 | 88057551.5 | 81535476.1 | 76246045 | 71821183.62 | 113166975.2 |
20.NPV at 8.12%(sum of row 19) | 213423883.71 | ||||||
21. IRR(of FCF row 17) | 26.69% | ||||||
22. PI=1+(NPV/Initial investment) | |||||||
ie.1+(213423883.71/313750000)= | 1.68 |
WACC calculations: |
After-tax Cost of debt: |
Given the following details |
Current selling price=1000*95%=950 |
Pmt.=Semi annual coupon pmt, ie.1000*6.25%/2= $ 31.25 |
r= the semi-annual yield ---we need to find out---?? |
n=No.of semi-annual coupon pmt. Periods still pending to maturity , 20 yrs.*2= 40 |
FV= Redemption value at maturity, ie. $1000 |
So, with these given values, we can use the following formula,to find the price of the bond ---to find its before-tax semi-annual yield as |
ie. Current Bond Price=(Pmt.*(1-(1+r)^-n)/r)+(FV/(1+r)^n) |
ie. 950=(31.25*(1-(1+r)^-40)/r)+(1000/(1+r)^40) |
3.354% |
Now the before-tax annual yield= |
(1+3.354%)^2-1= |
6.8205% |
so, the after-tax annual yield/cost of the bond= |
Before-tax annual yield*(1-Tax rate) |
ie.6.8205%*(1-28%)= |
4.91% |
Cost of Non-redeemable Preference shares |
$ dividends/Current market price |
ie.(10*6.5%)/32= |
2.03% |
Cost of Equity shares |
Year | Dividends ($) | Growth rate(Yr.n+1)-Yr.n)/Yr.n |
Year (-4) | 4.6 | |
Year (-3) | 4.8 | 4.35% |
Year (-2) | 5.2 | 8.33% |
Year (-1) | 5.3 | 1.92% |
Year (0) | 5.9 | 11.32% |
Sum | 25.92% | |
Av.=sum/4= | 6.48% |
So, next year dividend , taking the average growth rate of 6.48%= |
5.9*(1+6.48%)= |
6.28232 |
Cost of equity , ke,as per dividend discount model(assuming perpetual dividends) = |
ke= Next dividend/Current market price |
ie. 6.28232/55= |
11.42% |
Now, we shall find the Weighted average cost of capital(WACC) |
Type of capital | Mkt. value(in mlns.) | Wt. to total | Cost | Wt.*Cost |
Debt(given) | 120 | 9.03% | 4.91% | 0.44% |
Pref. shares(12*32) | 384 | 28.89% | 2.03% | 0.59% |
Equity(15*55) | 825 | 62.08% | 11.42% | 7.09% |
Total | 1329 | 100.00% | WACC= | 8.12% |
Plant depn. | |||
Year | depn. | Book value | |
0 | 295000000 | ||
1 | 73750000 | 221250000 | |
2 | 55312500 | 165937500 | |
3 | 41484375 | 124453125 | |
4 | 31113281.3 | 93339843.75 | |
5 | 23334960.9 | 70004882.81 | |
6 | 17501220.7 | 52503662.11 | Book value |
52000000 | Salvage value | ||
503662 | Loss on salvage | ||
141025 | Tax saved on loss at 28%(503662*28%) | ||
52141025 | ATCF on salvage(52 mln.+141025) |