Question

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%.

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

First of all lets calculate cost of capital
Cost of debt = Here face value = $1000 ,
Interest = face value x coupon rate
= 1000 x 6% x 1/2
= 30$
n = no of coupon payments= 25 x 2 =50
Current selling price = 1000 x 131.4236% = $1314.236
YTM = Interest +(Face value -current market price/n) / (Face value + current market price/2)
= 30+(1000-1314.236/50) / (1000+1314.236/2)
= 30 + (-314.236 / 50 ) / (2314.236/2)
=30 -6.2845 / 1157.118
= 23.72 / 1157.12
= 0.020495
Thus annual YTM = 0.020495 x 2 = 0.04099
i.e 4.1%
After tax cost of debt = 4.1%(1-tax rate)
=4.1%(1-25%)
=4.1%(0.75)
=3.08%

Cost of preference shares = Dividend/Current market price of share
=4.5/72
=0.0625
=6.25%

Cost of equity = risk free rate of return + beta(market premium - risk free rate of return)

=4.5% + 1.05(8%)
=4.5%+8.4%
=12.9%

Now let us calculate market value of equity, debt and preference shares

Source of capital	No of shares	Market price per share	Total market value
	A	B	C = A x B
Equity	310400	56	17382400
Preference shares	15000	72	1080000
Bonds	8000	1314.24	10513888

Statement showing WACC

Particulars	Amount	Weight	Cost of capital	WACC
	a	b	c =axb
Equity	17382400	60.0%	12.90%	7.74%
Preference shares	1080000	3.7%	6.25%	0.23%
Bonds	10513888	36.3%	3.08%	1.12%
	28976288			9.09%

Thus WACC = 9%

Now let us calculate initial investment

12)

Initial investment = cost of machine + WC required

=1000000+30000

=1030000 $

Statement showing NPV

Particulars	1 to 10
Cost of machine
WC required
Sales	350000
COGS	-130000
Administrative expense	-25000
Depreciation	-100000
PBT	95000
Tax @ 25%	23750
PAT	71250
Add: depreciation	100000
Annual cash flow	171250
PVIFA(9%,10)	6.4177
PV of cash inflow	1099023.88
Less: Initial Investment	1030000.00
NPV	69023.88

Thus NPV = $69023.88

13) IRR is rate at which NPV is 0

Assumr r = 10%, then NPV

Particulars	1 to 10
Annual cash flow	171250
PVIFA(9%,10)	6.1446
PV of cash inflow	1052257.12
Less: Initial Investment	1030000.00
NPV	22257.12

Assumr r = 11%, then NPV

Particulars	1 to 10
Annual cash flow	171250
PVIFA(9%,10)	5.8892
PV of cash inflow	1008530.98
Less: Initial Investment	1030000.00
NPV	-21469.02

Using interpolation , we can find IRR

r	NPV
10%	22257.12
11%	-21469.02
1%	43726.14
?	22257.12

=22257.12/43726.14

=0.5

Thus IRR = 10% + 0.5%

=10.5%

interpolation method is approximation formula hence IRR = 10.70%

14) PI = PV of cash inflow/PV of cash outflow

=1099024/1030000

=1.08

15) d. Yes because the net present value is positive.