Question

If possible in terms of a financial calculator

Question 1: Gibson Inc. Is evaluating making a new investment which will enhance its production of Les Paul guitars. The equipment will require an investment of $20 million and product cash flows of $30 million a year for 3 years. The company’s tax rate is 35%.

FCF (in millions)

-20

30

30

30

The company’s current balance sheet prior to the project is shown below:

Gibson Inc. Balance Sheet (in Millions)
Assets		Liabilities & Equity			Costs
Cash	10	Debt	160		Debt	5.5%
Other Assets	270	Equity	120		Equity	12.0%
Total Assets	280	Total Liabilities + Equity	280

1. Calculate the Levered WACC:
2. What is the Value of the Assets and Net Present Value of the Project?

Answer 1

Figures are in millions :

a) Levered WACC = (Weight of debt * Cost of debt * (1 - Tax rate)) + (Weight of equity * Cost of equity)

Here,

i) Weight of debt = Debt / (Debt + Equity)

Weight of debt = $160 / ($160 + $120)

Weight of debt = 0.57

ii) Weight of equity = 1 - Weight of debt

Weight of equity = 1 - 0.57

Weight of equity = 0.43

iii) Cost of debt = 5.5% or 0.055

iv) Cost of equity = 12% or 0.12

v) Tax rate = 35% or 0.35

Now,

Levered WACC = (0.57 * 0.055 * (1 - 0.35)) + (0.43 * 0.12)

Levered WACC = 0.0204 + 0.0516

Levered WACC = 0.0720 or 7.20%

b) i) Value of assets (prior to project) = $280 millions (Total assets)

Value of assets (after project) = Total assets + Investment cost of project

Value of assets (after project) = $280 + $20

Value of assets (after project) = $300 million

ii) Net present value of project = Present value (P. V.) of cash inflows - Investment costs

a) Investments costs = $20 million

b) P. V. Of cash inflows = Annual cash flows * ((1 - (1/(1+i)^n)) / i)

Here,

i (WACC) = 7.20% or 0.0720

n (years) = 3 years

Annual cash flows = $30 million

Now,

P. V. Of caah inflows = $30 million * ((1 - (1/(1+0.0720)^3))/0.072)

P. V. Of cash inflows = $30 million * ((1 - 0.8118)/0.072)

P. V. Of cash inflows = $30 million * 2.6139

P. V. Of cash inflows = $78.4170 million

Net present value of the project = $78.4170 million - $20 million

Net present value of the project = $58.4170 million