Question

Question 2

Dean & Deluca Ltd (D&D) is listed on Singapore Exchange and the following information was extracted from Thomson Reuters Eikon:

• Share price = $1.50

• Number of outstanding shares = 5 million

• Beta = 0.8

• Last traded price of each 5% bond = $920

• Bonds pay coupons semi-annually and mature in 6 years

• Face value of bond =$1,000

• Number of bonds issued = 5,000

• Yield on government long-term bond = 3%

• Equity risk premium = 6%

• Singapore corporate tax rate = 20%
  
  D&D has received a new order for its products. However, its machines are all working at full capacity. In order to accept the new order, the company needs to buy a new machine. The details relating to the order, the new machine, and other costs are shown below:
  

  YEAR	1	2	3
  SALES	$160,000	$180,000	$200,000

  
  Variable cost = 20% of sales
  The project requires an additional net working capital of $40,000, which is sufficient for the duration of the project.
  
  Cost of new machine = $300,000
  Life of machine = 3 years
  Salvage value of machine at end of 3 years = $60,000 Depreciation is a straight line over 3 years. Maintenance cost of machine per year = $10,000

(a) Calculate to estimate D&D’s cost of equity, cost of debt and weighted average cost of capital (WACC).

(b) Calculate the operating cash flows relating to the new order.

(c) Calculate the free cash flows relating to the new order.

(d) Assess and advise D&D whether it should accept the new order. Justify the choice of the method you use to make the decision.

Answer 1

Answer (a):

Cost of equity = Risk free rate + Beta * Market risk premium = 3% + 0.8 * 6% = 7.80%

Cost of debt:

Traded price of bond = $920

Face value = $1,000

Semiannual coupon = 1000 * 5% / 2 = $25

Time to maturity = 6 years = 6 * 2 = 12 semiannual periods

To calculate cost of debt we will use RATE function:

= RATE (nper, pmt, pv, fv, type)

= RATE (12, 25, -920, 1000, 0)

= 3.31908%

Cost of debt = 3.31908 * 2 = 6.64%

Market value of equity = 5 * $1.50 = $7.50 million

Market value of debt = 5000 * $920 = $4.60 million

Equity plus Debt = 7.50 + 4.60 = $12.10 million

WACC = Cost of equity * Equity % + before tax cost of debt * (1 - Tax rate) * Debt %

= 7.80% * 7.50 / 12.10 + 6.64% * (1 - 20%) * 4.60 / 12.10

= 6.85%

Hence:

Cost of equity = 7.80%

Cost of debt = 6.64%

WACC = 6.85%

Answer (b):

Free cash flows are calculated and given below:

Answer (d):

D&D is advised to accept the new order.

The NPV of the project at discount rate of 6.85% (WACC) is positive at $64,691.18

Hence project should be accepted. Choice of NPV is justifiable since it factors in time value of money and provides the value add to shareholders the project is expected to result in. It considers the cash flows over the life of the project.

The IRR is of the project is 15.67% which is greater than WACC of 6.85%.This evaluation criteria also suggests the project should be accepted.

Workings: