Question

Toyota is considering installing a new production line which is forecasted to start earning $5 million of revenue in the second year of operation. Revenue is projected to decrease at 10% p.a., operating costs are 25% of annual revenue and the production line is kept till the end of year 4, after which it is sold for $2 million. Setting up the production line requires $2 million today and $4 million in the first year. 40% Toyota capital is financed through equity which has a cost of 14% and the creditors are willing to charge 6% less than what the shareholders earn

(a) Draw timeline and set out the cash flows by year

(b) Calculate the required rate of return of this project

(c) What is the IRR of this project? Explain if Toyota should accept this project according to the IRR rule.

(d) What is the NPV of this project? Explain if Toyota should accept this project according to the NPV rule?

(e) If Toyota's credit rating upgrades from A to AA, holding other factors constant, explain

- how this change would affect WACC?

- how the IRR and NPV of the project and the capital budgeting decision made by using IRR approach and NPV approach would be affected

Answer 1

Solution:

a.Cash flow diagram is as follow

b)Calculation of required rate of return

Required rate of return shall be weighted average cost of capital(WACC)

WACC=Cost of equity*weight of equity+cost of debt*weight of debt

Cost of equity=14%

Cost of debt=14%-6%=8%

Weight of equity=40% or 0.40

Weight of debt=1-Weight of equity=0.60

WACC=14%*0.40+8%*0.60

=5.6%+4.8%=10.40%

Thus required rate of return is 10.40%

c)Calculation of IRR

IRR is the rate of return(discounting rate) at which NPV of the project is 0.Lets calculate the NPV of the project at 10.40% and 40%

Year	Cash flows(a)	Present value factor@(b)	Present value(a*b)
		10.40%	40%	10.40%	40%
1	-4000,000	0.906	0.714	-3624,000	-2856,000
2	3750,000	0.821	0.510	3078,750	1912500
3	3375,000	0.743	0.364	2507,625	1228500
4	3037,500	0.673	0.260	2044237.50	789,750
Salvage value	2000,000	0.673	0.260	1346,000	520,000
Sum of Present value	5352,612.50	1594,750
Less:Initial Cash outflows	2000,000.00	2000,000
Net Present value	3352,612.50	-405,25000

Now,IRR should be between 10.4% and 40%.IRR is calculated as follows

=Lower rate+NPV at lower rate/Sum of present value at(lower rate-higher Rate)*Higher rate-lower rate

=10.40%+{[3352,612.50/(5352,612.50-1594,750)]*40-10.40}

=10.40%+(3352,612.50/3757,862.50)*29.6

=10.40%+26.41%

=36.81%

Since the IRR(36.81%) is higher than the required return(10.40%),hence project should be accepted.

d)Calculation of NPV of the project

Discount rate=10.40%

Statement showing calculation of NPV

Year	Cash flows(a)	Present value [email protected]%	Present value(a*b)
1	-4000,000	0.906	-3624,000
2	3750,000	0.821	3078,750
3	3375,000	0.743	2507,625
4	3037,500	0.673	2044237.50
Salvage value	2000,000	0.673	1346,000
Sum of Present value	5352,612.50
Less:Initial Cash outflows	2000,000.00
Net Present value	3352,612.50

Since the NPV of the project is positive,hence project should be accepted.