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 a 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 and 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

a]

The timeline is below :

b]

Required return = (weight of equity * cost of equity) + (weight of debt * cost of debt)

Required return = (40% * 14%) + (60% * 8%)

Required return = 10.4%

c] and d]

NPV = sum of present values of all cash flowsl

Present value of each cash flow = cash flow / (1 + required return)ⁿ

where n = number of years after which the cash flow occurs.

IRR is calculated using IRR function in Excel as below :

The project should be accepted as per NPV rule because the NPV is positive.

The project should be accepted as per IRR rule because the IRR is higher than the required return.

e]

If the credit rating upgrades, the cost of debt will reduce because debt investors require a lower return. This will reduce the WACC. As a result, the NPV will be higher. So, there will be no change in the capital budgeting decision.

The IRR will be unchanged because IRR does not depend on WACC. So, there will be no change in the capital budgeting decision.