Question

In: Finance

New consideration (emergency). There was a huge mistake Capital Structure Debt 40% Interest rate 5% Tax...

New consideration (emergency).

There was a huge mistake

Capital Structure
Debt 40%
Interest rate 5%
Tax Rate 26%
Equity 60%
Risk Free rate 6%
RM 13%
Beta 1%
Working capital 10% next year's sales
No terminal cash flows
Project 1 Capital investment 1,000,000
Year Revenues Expenses
1 780,000 585,000
2 799,500 599,625
3 819,488 614,616
4 839,957 629,981
5 860,974 645,731
6 882,498 661,874
7 904,561 678,421
8 927,175 695,381
Instructions
a) Compute the cost of debt financing
b) Compute the cost of equity financing using the capital asset pricing model (CAPM)
c) Compute the waighted average cost of capital (WACC)
N.B. The capital investment is to be depreciatded as a 7 years asset
d) Evaluate the project by computing: 1) Net Present Value (NPV) 2) Internal rate of return 3) Payback
e) Decision is to accept or reject the projet (based on IRR and NPV)

Use excel chart

Solutions

Expert Solution

a after tax cost of debt interest rate*(1-tax rate) 5*(1-.26) 3.7
b cost of equity risk free rate+(market return-risk free rate)*beta 6+(13-6)*1 13
WACC
source weight cost weight*cost
debt 0.4 3.7 1.48
equity 0.6 13 7.8
c WACC = sum of weight*cost 9.28
Year 0 1 2 3 4 5 6 7 8
Initial investment -1000000
revenue 780000 799500 819488 839957 860974 882498 904561 927175
expenses 585000 599625 614616 629981 645731 661874 678421 695381
less depreciation = 1000000/7 142857.143 142857.14 142857.14 142857.1429 142857.1429 142857.1429 142857.1 0
operating profit 52142.8571 57017.857 62014.857 67118.85714 72385.85714 77766.85714 83282.86 231794
after tax profit = operating profit*(1-tax rate) 38585.7143 42193.214 45890.994 49667.95429 53565.53429 57547.47429 61629.31 171527.56
operating cash flow = after tax profit+ depreciation 181442.857 185050.36 188748.14 192525.0971 196422.6771 200404.6171 204486.5 171527.56
requiretment of working capital- 78000 79950 81948.8 83995.7 86097.4 88249.8 90456.1 92717.5 0
increase/ decrease of working capital -78000 -1950 -1998.8 -2046.9 -2101.7 -2152.4 -2206.3 -2261.4 92717.5
net operating cash flow = operating cash flow+increase or decrease in working capital -1078000 179492.857 183051.56 186701.24 190423.3971 194270.2771 198198.3171 202225.1 264245.06
present value of net operating cash flow = net operating cash flow/(1+r)^n r = 9.28% -1078000 164250.418 153282.32 143062.28 133523.4556 124653.0554 116373.9685 108655.1 129921.6078
d Net present value =sum of present value of cash flow -4277.7881
d IRR = using IRR function in MS excel =irr(cell reference year 0 net operating cash flow: cell reference year 8 net operating cash flow) 9.18%
Year 0 1 2 3 4 5 6 7 8
net operating cash flow = operating cash flow+increase or decrease in working capital -1078000 179492.857 183051.56 186701.24 190423.3971 194270.2771 198198.3171 202225.1 264245.06
d cumulative operating cash flow 179492.857 362544.41 549245.65 739669.0486 933939.3257 144060.6743
amount to be recovered in year 6
payback period year before final year of recovery+(amount to be recovered/cash flow of final year of recovery) 5+(144060.67/198198.31) 5.73
e Reject the project as IRR is less than WACC and NPV is negative

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