Question

As part of your new job responsibilities as an analyst for Lachute Lumber, you have been asked to help evaluate a new project. Lachute has a market value debt-to-equity ratio of .6667. The firm's cost of equity is 15% and its pre-tax cost of debt is 4.917%. Flotation costs of debt and equity are 1.71% and 5%, respectively. The firm has a tax rate of 40%.

The new project requires purchasing equipment that will cost $2,000,000 plus an additional $200,000 in shipping & installation costs and $50,000 in training costs. Management estimates that the firm will generate annual operating revenues before taxes of $1,000,000 and incur annual operating expenses before taxes of $500,000 over the economic life of the project. The economic life of the machine is ten years and management estimates that at the end of the economic life, the machine will have a salvage value of $200,000. This machine is in asset class 8 which has a CCA rate of 20%. The asset class is expected to remain open at the end of the project. Assume this project will have the same level of risk as the firm, flotation costs are expensed and the company has no internally generated funds available.

a) What is Lachute’s weighted average cost of capital?
b) Calculate the Initial Investment.
c) Calculate the PV of Operating (Incremental) cash flows after tax

d) Calculate the PV of the ending cash flows
e) Calculate the PV of the CCA tax shield
f) Calculate the NPV. Should the project be accepted?

Answer 1

After-Tax flotation cost of equity (5%(1-40%)) = 3%

a.Lachute's WACC=
(Wt.d*kd)+(Wt.e*ke)
ie.(0.6667/1.6667*(4.917+1.71)%*(1-40%))+
(1/1.6667*(15+3)%)=
12.39%
b.Initial investment
Cost of equipment	$       2,000,000
Shipping & installation	$          200,000
Training costs	$            50,000
Total	$      -2,250,000
c.PV of incremental opg.After-tax cash flows
(1000000-500000)*(1-40%)=
300000
P/A,300000,i=12.39%,n=10 yrs.
300000*5.56115=	$       1,668,345
d. PV of ending cash flows
ie.PV of After-tax salvage
Loss on salvage
216637/1.1239^10=	$            67,368
e.PV of CCA tax shields
As per table	$          537,171
f. NPV of the project
sum(b….e)	$            22,884
YES. It should be accepted

e.PV of CCA tax shields
Year	Depn.	Carrying value	ITS	PV F at 12.39%	PV at 12.39%
1	2=Prev.3*20%	3=prev.3-2	4=2*40%	1/1.1239^Yr.n	6=4*5
0		$      2,250,000
1	$          450,000	$      1,800,000	$      180,000	0.88976	$      160,157
2	$          360,000	$      1,440,000	$      144,000	0.79167	$      114,001
3	$          288,000	$      1,152,000	$      115,200	0.7044	$        81,146
4	$          230,400	$         921,600	$        92,160	0.62674	$        57,761
5	$          184,320	$         737,280	$        73,728	0.55765	$        41,114
6	$          147,456	$         589,824	$        58,982	0.49617	$        29,266
7	$          117,965	$         471,859	$        47,186	0.44148	$        20,831
8	$            94,372	$         377,487	$        37,749	0.39281	$        14,828
9	$            75,497	$         301,990	$        30,199	0.3495	$        10,555
10	$            60,398	$         241,592	$        24,159	0.31097	$          7,513
	$       2,008,408		$      803,363	5.56115	$      537,171
	Carrying Value			$         241,592
	Less:Salvage			$         200,000
	Loss on salvage			$           41,592
	Tax saved on loss(loss*40%)			$           16,637
	After tax salvage(200000+16637)			$         216,637