Question

A.
As the financial manager of Wilmore Company Limited, with a passion to boost employment creation through intraregional tourism in Ghana, you have acquired a land at Ho to put up an exquisite amusement park that features a number of attractions including games, pools, gardens, rides etc. The project will cost a total of GH₵100,000. The following cash flows are expected from the project. The beta of the project is 1.5 and the market return is 15%. The risk-free rate of return is 8%.

Year                                    ₵

   0                                     ( 100,000)    
   
   1                                      20,000
  
   2                                      25,000

   3                                      32,000

   4                                      35,000

(i) Using the CAPM approach, what is the cost of equity on this project?

(ii) Wilmore Company Limited is a levered entity with percentage of debt out of total capital being 40%. If the interest rate on a bank loan is 10%, the tax rate is 20%, and the cost of equity is as computed in (a), what will be the after tax cost of debt?

(iii) What will be the weighted average cost of capital (WACC)?

(iv) Using the WACC computed in (c), what will be the NPV of the investment? `
(v) Compute the IRR for the project?
(vi) What will be your overall advice concerning viability of the project?

Answer 1

(i) As per CAPM,

Cost of equity = risk free rate + ( Return on market - risk free rate) * beta

= 8 + ( 15 - 8) * 1.5

= 18.50%

(ii)

After tax cost of debt = cost of debt * ( 1 -tax rate ) = 10 * ( 1 - 0.2 ) = 8%

(iii)

weightage average cost of capital = weight of equity * cost of equity + weight of debt * after tax cost of debt

= 0.6 * 18.5 + 0.4 *8 = 14.30%

(iv)

Years	Cash flow (A)	Discounting Factor ( B=1/ (1+r)^n	Present value (A*B)
0	-$100,000	1	-$100,000.00
1	$20,000	0.874890639	$17,497.81
2	$25,000	0.76543363	$19,135.84
3	$32,000	0.669670717	$21,429.46
4	$35,000	0.585888641	$20,506.10
Net Present value	-$21,430.78

(v) IRR is the rate of return at which present valeu fo cash outflows = presnt vaue of cash inflows

-100000 = 20000 / 1.143 + 25000/1.143^2 + 32000/1.143^3 + 35000 /1.143^4

Let us use Financial calculator to solve the above

CF0	CF1	FR1	CF2	FR2	CF3	FR3	CF4	FR4	IRR< CPT
-100000	20000	1	25000	1	32000	1	35000	1	4.27

IRR = 4.27%

(vi) The project should not be accepted as it has negative NPV. It will lead to erosin of shareholders wealth.