Question

The following information pertains to Fairways Driving Range, Inc.:

The company is considering operating a new driving range facility in Sanford, FL. In order to do so, they will need to purchase a ball dispensing machine, a ball pick-up vehicle and a tractor and accessories for a total cost of $103,000. All of this depreciable equipment will be 5-year MACRS property. The project is expected to operate for 6 years, at the end of which the equipment will be sold for 25% of its original cost. Fairways expects to have $33,000 of fixed costs each year other than depreciation. These fixed costs include the cost of leasing the land for the driving range. Fairways expects to have sales for the first year of $103,000 based on renting 20,600 buckets of balls @ $5 per bucket. For years 2-6, they expect the number of buckets rented to steadily increase by 1,100 buckets per year, while the price will remain constant @ $4. Expenditures needed for buckets and balls each year are expected to be 23% of the gross revenues for the year. Fairways will be in the 35% tax bracket for all years in question.

The company has a required capital structure of 40% debt and 60% equity. They can issue new bonds to yield 5.5%. With respect to equity, the company’s beta is 1.85 the expected return on the market is 12% and the risk-free rate is 7%. Use this information to compute the company’s WACC and then use the WACC as the required return for this project. Please complete the following tables to determine the NPV for Fairways Driving Range, Inc.’s proposed Sanford venture. PLEASE ROUND ALL FIGURES TO THE NEAREST WHOLE DOLLAR!

For each year of the project, compute the profit margin and EPS (assuming that the firm has 16,000 shares of stock outstanding). Besides the net value of the fixed assets, the company also expects to have $20,000 of other assets. Compute the total assets for each year, use the 40%/60% ratio to determine the total amounts of liability and equity for each year, and use those figures to compute ROA and ROE for each year. Based on your financial analysis, prepare a paragraph or so of a summary from the stand point of a consultant. In this summary, provide your ideas about this project and what you think would be the best course of action for the company to follow and why. Remember to justify your answers with facts from your calculations as well as provide meaningful insight for the company.

0*

1

2

3

4

5

6

Sales

Variable Costs

Fixed Costs

Depreciation

EBIT

Taxes

Net Income

EBIT

Depreciation

Taxes

OCF

Net Capital Spending

Cash Flow From Assets

Present Value

NPV (just put overall NPV in Year 0 column)

Profit Margin

EPS

Total Assets

Total Liabilities

Total Equity

ROA

ROE

WACC Computation:

*The only amounts that you will have for year 0 will be Net Capital Spending, Cash Flow from Assets, Present Value and the overall NPV.

Answer 1

We will first calculate the WACC and then prepare the table:

Computation of WACC:

Proportion of debt in capital structure = Wd = 40%

Proportion of equity in capital structure = We = 60%

Pre tax cost of debt, Kd = bonds yield = 5.5%

Tax rate, T = 35%

Beta = 1.85

the expected return on the market, Rm = 12%

and the risk-free rate = Rf = 7%.

Hence, cost of equity, Ke = Rf + Beta x (Rm - Rf) = 7% + 1.85 x (12% - 7%) = 16.25%

WACC = Wd x Kd x (1 - T) + We x Ke = 40% x 5.5% x (1 - 35%) + 60% x 16.25% = 11.18%

--------------------------------

Net capital spending = Purchase cost = 103,000 in year 0

Post tax salvage value = 25% x 103,000 x (1 - T) = 25% x 103,000 x (1 - 35%) = 16,738

This value along with a negative sign appears as net capital spending under year 6. Hence, net capital spending in year 6 = - 16,738.

Total asset in any year = 103,000 + other asset of 20,000 - accumulated depreciation until that year.

Please see the table below. Please be guided by the second column titled “Linkage” to understand the mathematics. You can also understand the mathematics making use of [+] / [-] sign appearing in the first column. Figures in parenthesis, if any, mean negative values. All financials are in $.

Year, n	Linkage	0	1	2	3	4	5	6
Sale Volume (no. of units)	A		20,600	21,700	22,800	23,900	25,000	26,100
Sale Price / Unit	B		5	4	4	4	4	4
5 year MACRS Depreciation schedule	d		20.00%	32.00%	19.20%	11.52%	11.52%	5.76%
Sales	C = A x B		103,000	86,800	91,200	95,600	100,000	104,400
[-] Variable Costs	D = 23% x C		23,690	19,964	20,976	21,988	23,000	24,012
[-] Fixed Costs	E		33,000	33,000	33,000	33,000	33,000	33,000
[-] Depreciation	F = d x 103000		20,600	32,960	19,776	11,866	11,866	5,933
EBIT	G = C - D - E - F		25,710	876	17,448	28,746	32,134	41,455
[-] Taxes	H = 35% x G		8,999	307	6,107	10,061	11,247	14,509
Net Income	I = G - H		16,712	569	11,341	18,685	20,887	26,946
EBIT	G		25,710	876	17,448	28,746	32,134	41,455
[+] Depreciation	F		20,600	32,960	19,776	11,866	11,866	5,933
[-] Taxes	H		8,999	307	6,107	10,061	11,247	14,509
OCF	J = G + F - H	-	37,312	33,529	31,117	30,551	32,753	32,879
[-] Net Capital Spending	K	103,000	-	-	-	-	-	(16,738)
Cash Flow From Assets	L = J - K	(103,000)	37,312	33,529	31,117	30,551	32,753	49,616
Present Value	M = L x (1 + WACC)^(-n)	(103,000)	33,560	27,125	22,642	19,995	19,280	26,270
NPV (just put overall NPV in Year 0 column)	N = Sum of all M	45,872
Profit Margin	I / C		16.22%	0.66%	12.44%	19.55%	20.89%	25.81%
EPS	I / 16,000		1.04	0.04	0.71	1.17	1.31	1.68
Total Assets	P = 103,000 + 20,000 - accumulated depreciation		102,400	69,440	49,664	37,798	25,933	20,000
Total Liabilities	Q = P x 40%		40,960	27,776	19,866	15,119	10,373	8,000
Total Equity	R = P x 60%		61,440	41,664	29,798	22,679	15,560	12,000
ROA	I / P		16.32%	0.82%	22.84%	49.43%	80.54%	134.73%
ROE	I / R		27.20%	1.37%	38.06%	82.39%	134.24%	224.55%