Question

Cathy Smith from Cathy’s Cool Constructions Pty. Ltd. is considering investing in some equipment to expand her business and has asked for your advice regarding the 2 options she has available, and has given the information below. The company pays a 30% flat rate of company tax.

The current sources of funds and associated costs are as follows:

Source of funds	Value ($)	Cost % before tax
Owners’ Equity	$874,500	10.0%
Mortgage	$525,000	4.0%
Vehicle Loan	$41,000	12.0%

1B. Equipment Option 2 costs $100,000, will last 8 years and then become obsolete and be worth nothing. It is expected to bring in approximately $35,000 additional cash revenue each year and will require Cathy to take out an additional loan of $50,000, with an interest rate of 12%p.a. before tax.

i. Given the change in sources of funds and capital structure above, calculate the new Weighted Average Cost of Capital for Cathy’s Cool Constructions Pty. Ltd.

ii. Using the straight line method of depreciation, calculate the annual depreciation expense. Show your workings

iii. Calculate the additional profit per year after tax and the additional net cash inflow per year. Show your workings.

iv. What is the Average Rate of Return for Option 2?

Answer 1

after tax cost of debt
Mortgage Loan	Interest rate*(1-tax rate)	4*(1-.3)	2.8
vehicle Loan	Interest rate*(1-tax rate)	12*(1-.3)	8.4
Additional Loan	Interest rate*(1-tax rate)	12*(1-.3)	8.4
cost of equity			10
WACC
Source	value	Weight	component cost	weight*component cost
owner equity	874500	0.5867159	10	5.8671587
mortgage	525000	0.3522308	2.8	0.9862462
vehicle loan	41000	0.0275075	8.4	0.2310634
additional Loan	50000	0.0335458	8.4	0.2817846
total	1490500
WACC = sum of weight*component cost				7.3662529
Annual depreciation	cost of equipment-scrap value/life of equipment	(100000-0)/8		12500
Year	1	2	3	4	5	6	7	8
cash revenue	35000	35000	35000	35000	35000	35000	35000	35000
less depreciation	12500	12500	12500	12500	12500	12500	12500	12500
before tax profit	22500	22500	22500	22500	22500	22500	22500	22500
less tax-30%	6750	6750	6750	6750	6750	6750	6750	6750
after tax profit	15750	15750	15750	15750	15750	15750	15750	15750
add depreciation	12500	12500	12500	12500	12500	12500	12500	12500
net operating cash flow	28250	28250	28250	28250	28250	28250	28250	28250
Average rate of return	average after tax profit/average investment	15750/50000	31.50%
average after tax profit		15750
average investment	100000/2	50000