Question

Question 1

ABC company is considering producing a new range of smartphones that will require it to build a new factory. The project itself will go for 20 years. Feasibility studies have been done on the factory which cost $5 million. The studies have found the following:

1. The factory will cost $25 million and will have a useful life of 25 years.
2. The land where the factory will go is currently used as a carpark for workers and it is assumed that the company will have to pay $50000 per year for their workers to park in a nearby carpark.
3. The factory will be depreciated on a straight line basis and will have a salvage value of $0 but it is believed that most of it can be sold for scrap and parts after 20 years (at the end of the project) for $500000.
4. Due to the nature of the business they are in, they will have to perform some environmental tests to make sure that some of the chemicals they are using are not entering the ground water around the factory. These tests will be performed every 5 years and initially cost $625000 (in five years) and then increase at the rate of inflation which is predicted to be 2.5% per year.
5. Through the building of this factory and the selling of the phones it produces, it’s revenue will increase by $5 million in year 1 and then by 7% per year for 10 years and then decrease by 2% until the end of the project.
6. The extra costs that the company accrues per year due to the project are $400000 for labour, $45000 for overhead like power and water bills and marketing costs for the new line of phones will be $500000 per year but will decrease by 10% per year as the phone gains greater penetration. It is also predicted that labour costs will increase by 2% per year due to inflation.
7. The company’s current cost of capital is 5% per year.
8. The tax rate is 30%.
9. The project requires an initial investment in working capital of $1000000 and will be increased by 5% for the first 5 years of the project and then does not change until the end of the project. It is returned in year 20.

Use the above information to answer the following.
A. Calculate the free cash flows that come from this project for the 20 years it is operational.
B. Calculate the NPV, IRR and payback period of the project. Should they go ahead with the project?
C. Calculate the break-even point for the following variables :
a. The overhead.
b. The initial yearly revenue.
c. The initial labour cost.
d. The initial advertising cost.

Question 2

The figures used in questions 1 are based on a neutral economic forecast of the future. Below are two additional situations that could occur.

1. A long term boom would lead to revenue being 10% higher than as described above. In addition all costs would be 5% higher. The cost of capital will be 4%
2. A long term recession would lead to revenue being 10% lower than as described above. In addition all costs will be 3% lower. The cost of capital will be 12%.

Use this information to complete the following questions.
A. Perform a scenario analysis that shows how the NPV would change if these situations came to fruition. Comment on your results.
B. Imaginethatyoupredictthatbothoftheabovescenarioswouldoccurwith50% probability. Would this change your decision from question 1? Explain.

Question 3

After some research you find that the cost of capital you have been given in the previous questions was an arbitrary number someone thought was appropriate and is in fact not based on the fundamentals of the company. As such you take it upon yourself to calculate a more accurate measure. After doing some research you find the following information on the company’s capital structure:

1. The company has previously issued two types of bonds:
A. 10000 bonds with a face value of $1000 and a coupon rate of 6% that makes payments every quarter. The current yield is 10% and the bonds have 10 years to maturity.
B. 500 zero-coupon bonds with a face value of $10000 that have a 20 years to maturity. They currently have a yield of 12%.

2. The company’s beta (systematic risk) is 1.3, the expected return on the market is 7% and the risk free rate is 2%. There are 100000 shares on issue that currently sell for $15.26.

Using this information answer the following questions:
A. Calculate the cost of debt.
B. Calculate the cost of equity.
C. Calculate the WACC.
D. Recalculate the NPV and state whether your decision from question1 is changed.

Answer 1