Question

Can this be written out please, for my Bath Uni homework.

Cash Flow Analysis. You are considering a 5-year investment project which is expected to cost $1, 000, 000. In each year, you have decided that there are 3 possible states of the economy: good, average, and poor. In each individual year there is a 35% chance of the economy being good and a 15% chance of it being poor. You forecast the following net cash flows for the project:

Economy Year 1 Year 2 Year 3 Year 4 Year 5

Good 300,000 350,000 400,000 350,000 250,000

Average 250,000 275,000 325,000 275,000 175,000

Poor 200,000 225,000 250,000 225,000 150,000

(a) What is the expected net cash flow each year? You have arranged the following sources of funding:

(i) $200,000 from a 5-year fixed interest loan whose annual loan payments are $48,126.91.

(ii) $250,000 from a 5-year zero-coupon bond with a face value of $350,000.

(iii) $300,000 from an ordinary share issue where a dividend of $18,000 will be paid in one year and it is expected to grow at 3% per annum.

(iv) $250,000 from a 5-year coupon-paying bond issue whose coupon rate is 7% and face value is $250,000.

(b) what is the discount rate given above sources of financing? Hint: The discount rate should be the weighted average cost of capital.

(c) What is the NPV of this investment project and should you invest in this project?

Answer 1

Answer:

(a) Expected Cash Flow:

Year 1= 260,000

Year 2= 293,750

Year 3= 340,000

Year 4= 293,750

Year 5= 197,500

Details as follows:

(b) Calculation of Discount rate (WACC):

(i) Cost of loan (Rl)= 6.5% as follows:



Weight of loan in capital structure (Wl)= 200,000/1,000,000 =0.2

(ii ) Cost of Zero coupon Bond (Rz) = (350,000/250,000)^(1/5) – 1= 6.96104%

Weight of Zero coupon Bond in capital structure (Wz)= 250,000/1,000,000 =0.25

(iii ) Cost of equity share (Re) = 9.18% as follows:



Weight of equity in capital structure (We)= 300,000/1,000,000 =0.30

(iv ) Cost of coupon bond is the coupon rate since the price is equal to face value (issue at par). Hence cost of coupon bond (Rb)= 7%

Weight of coupon bond in capital structure (Wb)= 250,000/1,000,000 =0.25

Discount Rate (WACC)= Wl*Rl + Wz*Rz + We*Re +Wb*Rb

= 0.2*6.5% + 0.25*6.96104% + 0.30*9.18% + 0.25*7%

= 7.54426%

(c):

NPV of the project= $ 125,977.78 as follows:

Since NPV is positive, we shall invest in the project.

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