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Galaxy Industries Limited is a large publicly listed company and is the market leader in vacuum...

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:

Debt

$120,000,000,6.25% coupon bonds outstanding with 20 years to maturity redeemable at par, selling for 95 percent of par; the bonds have a $1000 par value each and make semi-annual coupon payments.

Equity

15,000,000ordinary shares, selling for $55 per share

Non-redeemable Preference shares

12,000,000 shares (par value $ 10 per share) with 6.5% dividends (after taxes), selling for $32 per share

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

Year (-4) ($)
Year (-3) ($)
Year (-2) ($)
Year (-1) ($)
Year (0) ($)
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.

Solutions

Expert Solution

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)

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