Question

QUESTION 1

1. Use the above information to answer Questions 1 - 17.

   Kentucky Hardware Company (KHC) is considering an investment project that requires a new machine for producing special tools.  This new machine costs $1,000,000 and will be depreciated over 10 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 $30,000 in net working capital.  The company pays $45,000 in interest expenses annually.  KHC has estimated the performance of the new machine and believes that the new machine will produce $350,000 per year in sales, $130,000 per year in cost of goods sold, and $25,000 per year in administrative expenses.

   In order to get an estimate of cost of capital, KHC collect the following information.  KHC has 310,400 shares of common stock outstanding, 15,000 shares of preferred stock outstanding, and 8,000 issues of corporate bond outstanding.  The bonds have face value $1,000 and coupon rate 6%.  The bonds make semiannual coupon payments, have 25 years to maturity, and sell for 131.4236% of par.  The common stock sells for $56 per share and has a beta of 1.05.  KHC’s next common stock dividend is expected to be $2.80 per share, and the common stock dividend is expected to grow at 7.7% indefinitely.  The preferred stock sells for $72 per share and pays $4.5 annual dividend.  The market risk premium is 8%, T-bills are yielding 4.5%, and KHC’s tax rate is 25%.

   How much money does KHC need to spend to start the investment project (i.e., project cash flow at time 0)?

   	a.	$2,530,000
   	b.	$2,030,000
   	c.	$1,030,000
   	d.	$30,000

0.5 points   

QUESTION 2

1. Should KHC include consulting fee, $50,000, in estimating project's cash flows?

   	a.	Yes.
   	b.	No.

0.5 points   

QUESTION 3

1. Should KHC include interest expenses, $45,000, in estimating project's cash flows?

   	a.	No.
   	b.	Yes.

0.5 points   

QUESTION 4

1. What is the project cash flow at Year 10?

   	a.	$171,250
   	b.	$141,250
   	c.	$201,250
   	d.	$100,250

0.5 points   

QUESTION 5

1. What is the cost of preferred stock for KHC?

   	a.	6.25%
   	b.	6.25
   	c.	16
   	d.	16%

0.5 points   

QUESTION 6

1. What is the after-tax cost of debt for KHC?

   	a.	3%
   	b.	2%
   	c.	4%
   	d.	5%

0.5 points   

QUESTION 7

1. What is KHC's cost of equity estimated by using the capital asset pricing model?

   	a.	15.4%
   	b.	14.1%
   	c.	12.9%
   	d.	10.2%

0.5 points   

QUESTION 8

1. What is KHC's cost of equity estimated by using the dividend growth model?

   	a.	12.7%
   	b.	9.5%
   	c.	13.1%
   	d.	10.2%

0.5 points   

QUESTION 9

1. What is KHC's market value capital structure?

   	a.	$19,285,318
   	b.	$31,517,788
   	c.	$37,361,828
   	d.	$28,976,288

0.5 points   

QUESTION 10

1. What is the weighted average cost of capital for KHC?

   	a.	6%
   	b.	12%
   	c.	15%
   	d.	9%

1 points   

QUESTION 11

1. What is the payback period for the investment project?

   	a.	5.21 years
   	b.	6.01 years
   	c.	7.86 years
   	d.	6.82 years

0.5 points   

QUESTION 12

1. What is the net present value for the investment project?

   	a.	$69,023.88
   	b.	$25,278.31
   	c.	-$40,645.72
   	d.	$81,696.56

1 points   

QUESTION 13

1. What is the internal rate of return for the investment project?

   	a.	10.7%
   	b.	9.4%
   	c.	11.3%
   	d.	8.6%

1 points   

QUESTION 14

1. What is the profitability index for the project?

   	a.	1.98
   	b.	1.08
   	c.	-0.87
   	d.	0.97

0.5 points   

QUESTION 15

1. Should KHC accept the project?

   	a.	No because the internal rate of return is higher than the cost of capital.
   	b.	No because the profitability index is negative.
   	c.	Yes because the payback period is longer than the project life.
   	d.	Yes because the net present value is positive.

0.5 points   

QUESTION 16

1. What is the maximum price that KHC has to pay if the target profitability index is 1.2?

   	a.	$926,413.80
   	b.	$915,853.23
   	c.	$999,112.62
   	d.	$982,439.50

0.5 points   

QUESTION 17

1. What is the minimum annual cash flow that project has to generate in order to accept the project?

   	a.	$329,597.61
   	b.	$160,494.64
   	c.	$145,396.85
   	d.	$316,297.91

Answer 1

Q1. Givent the information we have -

Cost of new machine = $1,000,000 , Net working capital required = $30,000

Amount spent on consulting studies = $50,000 , Interest payments (annual) = $45,000

At To, the cash required would be the cost of project and the net working capital required. The working capital is required right at the start to make the project operational. Besides, consulting studies were taken up a year ago and these are sunk costs so they will not be included. Sunk costs are costs that have already been incurred by the firm and are not recoverable. If the project is rejected, these costs still cannnot be recovered. So these costs will not be a part of our analysis.

Further, interest expenses, operating expenses, etc are incurred at T1 and will not be a part of initial cash fow that we are supposed to compute.

Hence, initial cash flow = Cost of machine + Net working capital required

= $1,000,000 + $30,000

= $1,030,000 (Option c)

Q2. The amount of cash flows are sunk costs. Sunk costs are those costs that have already been incurred by the firm and are not recoverable. They are also not incremental to a project. Although ,market study was done to understand the demand for special tools that are produced by this new machine, this cost is a cost to understand potential market. The project's implementation does not affect this cost. The cost has been incurred, whether the firm decides to go with the project or not. So these costs will not be considered while estimating the project's cash flows. The consulting cost is a part of company's costs but not that of this particular project as for cash flow analysis for a project, we only include costs that are directly affected as a result of project's implementation. Consulting studies were already completed before project could be implemented, they are neither incremental to project, nor recoverable in case of rejection of project.

Therefore, these costs will not be a part of our cash flow considerations. (Option b)

Q3. Interest expenses of $45,000 will not be a part of project's cash flows. This is because this is a financing cost (related to the funds raised by the firm). Financing costs are not included in a project's cash flow analysis as this will lead to double - counting. This is known as Interest Exclusion Principal. When we discount the project cash flows at weighted average cost of capital (WACC), this cost of funds is already counted in our WACC calculation. Including the interest expenses in the analysis will lead to this cost being deducted twice and thus will not be helpful in evalauting the proposals correctly. Acceptable proposals may get rejected due to this error of including interest in project cash outflows. Thus we do not include these costs in project cash flow analysis. (Option a)

Q4. As per question we have,

Sales per year = $350,000 , Cost of goods sold = $130,000 , Administrative expenses = $25,000

Tax rate = 25%

Also cost of machine = $1,000,000 , Salvage value of machine = 0 , Time = 10 years

So, depreciation = Cost of machine / No. of years

= $1,000,000 / 10

= $100,000

So cash flows = (Sales - Cost of goods sold - Depreciation - Administrative expenses - Tax) + Depreciation added back  

Cash flows = (Profit before tax - Tax) + Depreciation added back

Cash flows = ($350,000 - $130,000 - $100,000 - $25,000 - 25 % tax) + $100,000

= ($95,000 - tax @ 25%) + $100,000

= ($95,000 - $23,750) + $100,000

= $71,250 + $100,000

= $171,250

Further, net working capital invested at the start will also be recovered at the end of Year 10, so this will also be part of Year 10 cash flows.

The question states that the firm invests $30,000 in net working capital.

So, cash flows for Year 10 = Annual cash flows (calculated above) + Net working capital recovered

= $171,250 + $30,000

= $201,250

So required cash flows at Year 10 are $201,250. (Option c)

Note - We have not discounted the cash flow for year 10 as we have been asked about amount of cash flows at Year 10 and not their present value at To.