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%

1A. Equipment Option 1 costs $50,000, will last 5 years and then become obsolete and be worth nothing. It is expected to bring in approximately $18,000 additional cash revenue each year.

i. Given the current sources of funds and capital structure above, calculate the 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 1?

v. What is the Payback Period (in years) for Option 1?

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
cost of equity			10
WACC
Source	value	Weight	component cost	weight*component cost
owner equity	874500	0.6070809	10	6.0708087
mortgage	525000	0.3644568	2.8	1.020479
vehicle loan	41000	0.0284623	8.4	0.2390837
total	1440500
WACC = sum of weight*component cost				7.3303714
Annual depreciation	cost of equipment-scrap value/life of equipment	(50000-0)/5		10000
Year	1	2	3	4	5
cash revenue	18000	18000	18000	18000	18000
less depreciation	10000	10000	10000	10000	10000
before tax profit	8000	8000	8000	8000	8000
less tax-30%	2400	2400	2400	2400	2400
after tax profit	5600	5600	5600	5600	5600
add depreciation	8000	8000	8000	8000	8000
net operating cash flow	13600	13600	13600	13600	13600
Average rate of return	average after tax profit/average investment	5600/15000	37.33%
average after tax profit		5600
average investment	50000/2	25000
PaybacK period in years	Initial Investment/annual net operating cash flow	50000/13600	3.68