Question

Kentucky Hardware Company (KHC) is considering an investment project that requires a new machine for producing special tools. This new machine costs $900,000 and will be depreciated over 5 years on a straight-line basis toward zero salvage value. KHC paid a consulting company $50,000 last year to help them decide whether there is sufficient demand for the special tools. In addition to the investment on the machine, KHC also invests $40,000 in net working capital. The company pays $58,800 in interest expenses annually. KHC has estimated the performance of the new machine and believes that the new machine will produce $460,000 per year in sales. The cost of goods sold is 35% of sales and the administrative expenses is $35,000 per year.

In order to get an estimate of cost of capital, KHC collect the following information. KHC has 31,375 shares of common stock outstanding, 1,700 shares of preferred stock outstanding, and 980 issues of corporate bond outstanding. The bonds have face value $1,000 and coupon rate 6%. The bonds make semiannual coupon payments, have 15 years to maturity, and sell for 90.80398% of par. The common stock sells for $65 per share and has a beta of 1.1. KHC’s next common stock dividend is expected to be $2.60 per share, and the common stock dividend is expected to grow at 7.6% indefinitely. The preferred stock sells for $80 per share and pays $7.04 annual dividend. The expected return of market portfolio is 11.5%, T-bills are yielding 2.5%, and KHC’s tax rate is 20%.

What is KHC's project cash flow expected to be generated by the investment project at Year 5?

	a.	$171,250
	b.	$247,550
	c.	$297,500
	d.	$287,200 What is KHC's after-tax cost of debt? a. 7.0% b. 5.6% c. 3.1% d. 4.8% What is KHC's cost of preferred stock? a. 6.25 b. 6.25% c. 8.8 d. 8.8% What is KHC's cost of equity estimated by using the dividend growth model? a. 13.8% b. 11.6% c. 12.7% d. 14.5% What is KHC's cost of equity estimated by using the capital asset pricing model? a. 12.4% b. 13.5% c. 15.8% d. 14.1% What is the market value of KHC’s capital structure? a. $10,517,760 b. $28,957,760 c. $3,065,254 d. $7,362,531 What is KHC's weighted average cost of capital? a. 11% b. 12% c. 9% d. 10% What is the payback period for KHC's investment project? a. 4.32 years b. 6.01 years c. 3.23 years d. 3.80 years What is the net present value for KHC's investment project? a. $21,918.67 b. -$42,645.72 c. $69,023.88 d. -$25,278.31 What is the internal rate of return for KHC's investment project? a. 11.23% b. 12.45% c. 9.91% d. 10.89% What is the profitability index for KHC's investment project? a. 1.02 b. 0.98 c. -1.02 d. -0.98 What is the maximum price that KHC has to pay to start the investment project if the target profitability index is 1.1? a. $915,853.23 b. $874,471.52 c. $835,637.14 d. $929,112.67 What is the minimum annual cash flow that KHC's investment project has to generate in order to accept the project? a. $250,494.70 b. $279,597.60 c. $247,969.80 d. $216,297.90

Answer 1

1) Ans) d. $287,200

Particulars	Amount
Sales	460000
Less:
COGS (460000 x 35%)	161000
Sales and administrative expense	35000
Depreciation	180000
PBT	84000
Tax @ 20%	16800
PAT	67200
Add: Depreciation	180000
Annual Cash flow	247200
Release of WC	40000
Total cash flow at end of year 5	287200

Thus Total cash flow at end of year 5 = 287200$

2) Ans b. 56%

After tax cost of debt

here Face value = $1000
Interest = Face value x coupon rate
=1000 x 6% x 1/2
=30$
n = no of coupon payments = 15 x 2 = 30
Current market price = 1000 x 90.80398%
=908.0398 $
YTM = Interest +(Face value -current market price/n) / (Face value + current market price/2)
=30 + (1000-908.0398)/30 / (1000+908.0398)/2
= 30 + (91.96020/30) / 1908.0398/2
= 30 + 3.06534 / 954.0199
= 33.06534 / 954.0199
= 0.03465
Annual YTM = 0.03465 x 2 = 0.069318
i.e 6.9318 %
After tax cost of debt = 6.9318%(1-tax rate)
=6.9318%(1-20%)
=6.9318%(1-0.2)
=6.9318%(0.8)
= 5.55%
i.e 5.6%

3) Ans) d. 8.8%

Cost of preference shares = Dividend / Price per preference shares
=7.04/80
=0.088
i.e 8.8%

4) Ans) b.11.6%

Cost of equity as per dividend growth model = Expected Dividend / Po + g
g = growth rate = 7.6%
Expected dividend = $2.60
Po = price of share = $65
= 2.60/65 + 7.6%
=0.04 + 0.076
=0.1160
i.e 11.60%