Question

You run a company (Alpha) that is trying to enter the ice cream industry. The new line production requires an investment of 600,000 today and will be depreciated within 12 years with straight line depreciation method. In the 12th year the machine will be worth 3,500. Sales are estimated at 100,000 for each year but after the 12th year production will stop. The annual operating costs are 15,000 per year.

There are two competing companies (which have a 50% market share) Delta and Epsilon with the following financial data:

COMPANY	Beta	D/E	ROD
Alpha	0.7	0.6	5%
Delta	0.3	0.3	3%
Epsilon	0.2	0.4	2%

The interest-free rate is 1%, the expected market return is 8% and the tax rate is 24%. If all of the above sizes are on an annual basis, do you think that this investment should be made?

Answer 1

Since D/E ratio for Alpha is 0.6, hence weights will be calculated as follows:

Weight for debt = 0.6 / 1.6 = 0.375

Weight for equity = 1.0 / 1.6 = 0.625

Computation of Weighted average cost of capital

Return of equity (Ke) = Rf + Beta (Rm-Rf) = 1% +0.7 (8% - 1%) = 5.9%

Return of debt (Kd) = 5% (Assumed to be net of tax)

WACC = Ke * We + Kd*Wd

= 5.9% *0.625 + 5%*0.375

= 5.5625%

Depreciation = (Cost - Salvage value) / Useful life

= (600,000 - 3,500) / 12

= 49,708. 33

Year	Initial cost (A)	Annual revenue (B)	Salvage value (C)	Depreciation (D)	Cash flows before tax (E)= (A) to (D)	Tax @ 24%	Cash flows after tax (F)	Depreciation (G)	Net cash flows (H)= (F) +(G)	PVF @ 5.5625% (E)	Net present value (H)*(E)
0	(600,000)	-	-	-	(600,000)	-	(600,000)	-	(600,000)	1.000	(600,000)
1	-	10,000	-	(49,708)	(39,708)	9,530	(30,178)	49,708	19,530	0.947	18,501
2	-	10,000	-	(49,708)	(39,708)	9,530	(30,178)	49,708	19,530	0.897	17,526
3	-	10,000	-	(49,708)	(39,708)	9,530	(30,178)	49,708	19,530	0.850	16,602
4	-	10,000	-	(49,708)	(39,708)	9,530	(30,178)	49,708	19,530	0.805	15,728
5	-	10,000	-	(49,708)	(39,708)	9,530	(30,178)	49,708	19,530	0.763	14,899
6	-	10,000	-	(49,708)	(39,708)	9,530	(30,178)	49,708	19,530	0.723	14,114
7	-	10,000	-	(49,708)	(39,708)	9,530	(30,178)	49,708	19,530	0.685	13,370
8	-	10,000	-	(49,708)	(39,708)	9,530	(30,178)	49,708	19,530	0.649	12,666
9	-	10,000	-	(49,708)	(39,708)	9,530	(30,178)	49,708	19,530	0.614	11,998
10	-	10,000	-	(49,708)	(39,708)	9,530	(30,178)	49,708	19,530	0.582	11,366
11	-	10,000	-	(49,708)	(39,708)	9,530	(30,178)	49,708	19,530	0.551	10,767
12	-	10,000	3500	(49,708)	(36,208)	8,690	(27,518)	49,708	22,190	0.522	11,589
Net present value of new proposal											(430,875)

Since the NPV of new proposal is negative, hence it is not recommended to make the investment.