Question

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The Edmonton Fabricating Company (EFC) manufactures snow blowers. EFC is investigating the feasibility of a new line of cordless snow blower. The new manufacturing equipment to produce the new line of snow blower will cost $750,000. The installation costs are expected to be $25,000, the setup costs are expected to be $30,000 and the training costs are expected to be $15,000. The company has just finished a marketing feasibility and this study strongly endorses going ahead with a further financial study to evaluate the overall feasibility of the project. The cost of the marketing study was $35,000. The projected useful life of the new equipment is 8 years and the project unit sales are expected to be: YEAR UNIT SALES 1 3,000 2 3,300 3 3,500 4 3,700 5 4,000 6 4,250 7 4,300 8 4,300 The new cordless snow blower would be priced to sell at $250 per unit and the variable operating costs are expected to be 50% of sales. After the first year, the sales price is estimated to increase by 3% every year. The total fixed operating costs are expected to be $200,000 per year and would remain constant over the life of the project. The project would require $45,000 in working capital at the start (time period zero). The entire amount of working capital will be recovered at the end of the project. The estimated salvage value of the equipment after 8 years is $55,000. The marginal tax rate is 35%. The CCA rate of the equipment is 30%. The company uses the DCF model to determine the cost of retained earnings and new common stock. You have been provided with the following data: D0 = $1.00; P0 = $25.00; g = 7.00% (constant) and F=10.00%. The company’s 8.00% coupon rate, semi-annual payment, $1,000 par value bond that matures in 20 years sells at a price of $1,100. The new bonds would be privately placed with no flotation costs. The target capital structure is 50% debt, 30% common equity (retained earnings) and 20% equity (new common stock). REQUIRED: What is the net present value of this project? Should the project be undertaken by Edmonton Fabricating Company (EFC)?

Answer 1

Solution:

The formula of the constant growth rate model is as follows:

P0 = [D0 (1 + g)] / (Ke – g)

25 = [1 (1 + 0.07)] / (Ke – 0.07)

25 (Ke – 0.07) = 1.07

Ke = 11.28%

Hence, the Ke is 11.28%.

P0 is the price of the share as of now.

D0 is the dividend paid.

g is the growth rate.

Ke is the cost of equity.

The formula to calculate the cost of debt (Kd) is as follows:

Kd = [Coupon amount + (Maturity value – B0) / n] / (maturity value + B0) / 2

      = [40 + (1,000 – 1,100) / 40] / (1,000 + 1,100) / 2

      = 3.57% semi annually

      = 3.57% * 2

      = 7.14% p.a.

Hence, the Kd is 7.14%.

B0 is the value of bond as on now.

n is the total number of periods (in case of semi-annual payments, number of periods * 2).

The overall cost of the company or the weighted average cost of capital (WACC) can be calculated using the following formula:

WACC = (Ke * We) + (Kd * Wd) + (Kr * Wr)

             = (11.28% * 20%) + (7.14% * 50%) + (11.28% * 30%)

             = 9.21%

Hence, the WACC is 9.21%.

We is the weight of equity.

Wd is the weight of debt.

Kr is the cost of reserves and surplus.

Wr is the weight of reserves and surplus.

The Kr is not given in the question. Therefore, in such cases it will be assumed Kr = Ke.

The cost of the new project in year 0 can be calculated as follows:

Total cost = cost of new manufacturing equipment + installation cost + set-up cost + training cost + working capital

                 = 750,000 + 25,000 + 30,000 + 15,000 + 45,000

                 = 865,000

Hence, the total cost incurred in year 0 is $865,000.

Calculation of the profit on sale can be made as follows:

Profit on sales = Cost – depreciation – selling price

                        = 820,000 – 772,729 – 55,000

                        = 7,729

Hence, the profit on sales is $7,729.

Calculation of net SV can be made as follows:

Net SV = SV – tax paid on profit on sales

            = 55,000 – (7729*30%)

            =52,681

Hence, the net SV is $52,681.

The NPV of the project can be calculated as follows using MS-Excel.

Calculation of total sales and variable cost
Years	Sales units	Selling price	Sales	Variable cost
1	3000	250	750000	375000
2	3300	257.5	849750	424875
3	3500	265.2	928287.5	464143.75
4	3700	273.2	1010772.475	505386.2375
5	4000	281.4	1125508.81	562754.405
6	4250	289.8	1231728.704	615864.352
7	4300	298.5	1283606.219	641803.1094
8	4300	307.5	1322114.405	661057.2027

Calculation of the revenue
Years	Sales	Variable cost	Fixed cost	Revenue
0
1	750000	375000	200000	175000
2	849750	424875	200000	224875
3	928287.5	464143.75	200000	264143.8
4	1010772.5	505386.2375	200000	305386.2
5	1125508.8	562754.405	200000	362754.4
6	1231728.7	615864.352	200000	415864.4
7	1283606.2	641803.1094	200000	441803.1
8	1322114.4	661057.2027	200000	461057.2

Calculation of tax
Years	opening values	Depreciation	Closing values
1	820000	246000	574000
2	574000	172200	401800
3	401800	120540	281260
4	281260	84378	196882
5	196882	59064.6	137817.4
6	137817	41345.22	96472.18
7	96472	28941.654	67530.526
8	67531	20259.1578	47271.3682

Calculation of the free cash flows
Years	Cost price	Revenue	Depreciation	PBT	Tax	PAT	Depreciation	Cash flows	PVF @ 9.21%	PV
0	-865000	0	0	-865000				-865000	1	-865000
1	0	175000	246000	-71000	-21300	-49700	246000	196300	0.916	179811
2	0	224875	172200	52675	15803	36873	172200	209073	0.838	175203
3	0	264143.8	120540	143604	43081	100523	120540	221063	0.768	169776
4	0	305386.2	84378	221008	66302	154706	84378	239084	0.703	168076
5	0	362754.4	59064.6	303690	91107	212583	59064.6	271647	0.644	174941
6	0	415864.4	41345.22	374519	112356	262163	41345.22	303509	0.589	178767
7	0	441803.1	28941.654	412861	123858	289003	28941.654	317945	0.54	171690
8	0	461057.2	20259.1578	440798	132239	308559	20259.1578	426499	0.494	210690
NPV	563954

The project gives positive NPV. Therefore the project is feasible.