Question

A firm is deciding on a new project. Use the following information for the project evaluation and analysis: - The initial costs are $900,000 for fixed assets. The fixed assets will be depreciated straight line to a zero book value over the 3-year life of the project. The fixed assets have an estimated salvage value of $60,000 at the end of the project. - The project also requires an additional $200,000 for net working capital. All of the net working capital will be recouped at the end of the 3 years. - The project is expected to generate sales of $2,000,000 (2,000 units at a sales price of $1,000/unit), incur total costs of $1,500,000 per year (comprised of variable cost of $500 per unit and fixed costs of $500,000). - The firm’s marginal tax rate is 40 percent. - The company has 50,000 shares of common stock outstanding at a market price of $25 a share. The stocks have a beta of 1.5. The risk free rate is 1%, and the market risk premium is 10%. - There are 1,000 bonds outstanding which mature in 13 years, have a face value per bond of $1,000, and are currently quoted at $1,250 each. The bonds have a coupon rate of 10 percent. - The target capital structure is 50% debt and 50% equity. a) What is the Operating Cash Flow for each year of the project? b) What is the after-tax salvage value at the end of this project? c) What are the Cash Flows from Assets each year for this project? Year 0 1 2 3 OCF ∆ NWC NCS CFFA d) Next we are going to calculate WACC (part d) through h)). What is the capital structure weight of equity (wE)? e) What is the capital structure weight of debt (wD)? f) What is the cost of Debt (RD)? g) What is the cost of Equity (RE)? h) What is the WACC for this firm, if the corporate tax rate is 40%?

Answer 1

1-
Year	0	1	2	3
Initial investment	-900000
net working capital	-200000
sales		2000000	2000000	2000000
less total cost		1500000	1500000	1500000
less depreciation =900000/3		300000	300000	300000
operating profit		200000	200000	200000
tax rate -40%		80000	80000	80000
after tax profit		120000	120000	120000
add depreciation		300000	300000	300000
operating cash flow		420000	420000	420000
2-
after tax salvage value	(salvage value-book value)*(1-tax rate)	(60000-0)*(1-.4)		36000
3-
operating cash flow		420000	420000	420000
after tax salvage value =60000*(1-.4)				36000
recovery of working capital				200000
cash flow from each year from asset		420000	420000	656000
capital structure weight			weight	weight
market value of debt	1250*1000	1250000	1250000/2500000	50%
market value of equity	50000*25	1250000	1250000/2500000	50%
total		2500000		100%
before tax cost of debt	Using rate function in MS excel	rate(nper,pmt,pv,fv,type) nper = 13 pmt = 100 pv = -1250 fv =1000 type =0	RATE(13,100,-1250,1000,0)	7.01%
after tax cost of debt in %	before tax cost of debt*(1-tax rate)	7.01*(1-.4)	4.21
cost of equity = risk free rate+(market premium)*beta	1+(10)*1.5	16
WACC of firm in % =(weight of debt*after tax cost of debt)+(weight of equity*cost of equity)	(.5*4.21)+(.5*16)	10.11