You are proposing a new venture, to branch out into animals and cartoon characte
ID: 2633358 • Letter: Y
Question
You are proposing a new venture, to branch out into animals and cartoon characters but this will require some new equipment and a capital outlay. Pertinent financial information is given below.
BALANCE SHEET
Cash
2,000,000
Accounts Payable and Accruals
18,000,000
Accounts Receivable
28,000,000
Notes Payable
40,000,000
Inventories
42,000,000
Long-Term Debt
60,000,000
Preferred Stock
10,000,000
Net Fixed Assets
133,000,000
Common Equity
77,000,000
Total Assets
205,000,000
Total Claims
205,000,000
Last years sales were $225,000,000.
The company has 60,000 bonds with a 30-year life outstanding, with 15 years until maturity. The bonds carry a 10 percent annual coupon, and are currently selling for $874.78.
You also have 100,000 shares of $100 par, 9% dividend perpetual preferred stock outstanding. The current market price is $90.00. Any new issues of preferred stock would incur a $3.00 per share flotation cost.
The company has 10 million shares of common stock outstanding with a currently price of $14.00 per share. The stock exhibits a constant growth rate of 10 percent. The last dividend (D0) was $.80. New stock could be sold with 15% flotation costs.
The risk-free rate is currently 6 percent, and the rate of return on the stock market as a whole is 14 percent. Your stocks beta is 1.22.
Stockholders require a risk premium of 5 percent above the return on the firms bonds.
The firm expects to have additional retained earnings of $10 million in the coming year, and expects depreciation expenses of $35 million.
Your firm does not use notes payable for long-term financing.
The firm considers its current market value capital structure to be optimal, and wishes to maintain that structure. (Hint: Examine the market value of the firms capital structure, rather than its book value.)
The firm is currently using its assets at capacity.
The firms management requires a 2 percent adjustment to the cost of capital for risky projects.
Your firms federal + state marginal tax rate is 40%.
Your firms dividend payout ratio is 50 percent, and net profit margin was 8.89 percent.
The firm has the following investment opportunities currently available in addition to the expansion you are proposing:
Project
Cost
IRR
A
10,000,000
20%
B
20,000,000
18%
C
15,000,000
14%
D
30,000,000
12%
E
25,000,000
10%
Your expansion would consist of a new product introduction (You should label your venture as Project I, for introduction). You estimate that your product will have a six-year life span (after all how many people will really buy this stuff), and the equipment used to manufacture the project falls into the MACRS 5-year class. Your venture would require a capital investment of $15,000,000 in equipment, plus $2,000,000 in installation costs. The venture would also result in an increase in accounts receivable and inventories of $4,000,000. At the end of the six-year life span of the venture, you estimate that the equipment could be sold at a $4,000,000 salvage value.
Your venture, which management considers fairly risky, would increase fixed costs by a constant $1,000,000 per year, while the variable costs of the venture would equal 30 percent of revenues. You are projecting that revenues generated by the project would equal $5,000,000 in year 1, $10,000,000 in year 2, $14,000,000 in year 3, $16,000,000 in year 4, $12,000,000 in year 5, and $8,000,000 in year 6.
The following list of steps provides a structure that you should use in analyzing your new venture.
Note: Carry all final calculations to two decimal places.
Find the WACC:
1. Find the costs (rate of return under current market conditions) of the individual capital components:
a. long-term debt (Hint: PV=-$874.78, FV = $1000, PMT=$100, n=15 solve for i)
b. preferred stock
c. retained earnings (avg. of CAPM and bond yield + risk premium approaches)
d. new common stock
2. Compute the value of the long-term elements of the capital structure, and determine the target percentages for the optimal capital structure. (Carry weights to four decimal places. For example: 0.2973 or 29.73%)
Find the Cash Flow from the project:
3. Compute the Year 0 investment for Project I.
4. Compute the annual operating cash flows for years 1-6 of the project.
5. Compute the additional non-operating cash flow at the end of year 6.
Find alternative capital budgeting measures:
6. Compute the IRR and payback period for Project I.
7. Determine your firms cost of capital. (Hint this is the WACC plus an adjustment from the write up)
Make Some Decisions:
8. Compute the NPV for Project I. Should management adopt this project based on your analysis? Explain. Would your answer be different if the project were determined to be of average risk? Explain.
9. Indicate which of the other projects (A through E) should be accepted and why.
Cash
2,000,000
Accounts Payable and Accruals
18,000,000
Accounts Receivable
28,000,000
Notes Payable
40,000,000
Inventories
42,000,000
Long-Term Debt
60,000,000
Preferred Stock
10,000,000
Net Fixed Assets
133,000,000
Common Equity
77,000,000
Total Assets
205,000,000
Total Claims
205,000,000
Explanation / Answer
5) Computation of year 0 Investment for project I:-
Year 0 Investment = Capital investment in equipment + Installation costs + Working capital
Year 0 Investment = 15,000,000 + 2,000,000 + 4,000,000
Year 0 Investment = $21,000,000
6) Computation of annual operating cash flows for years 1-6 of the project:-
Year 0 1 2 3 4 5 6
Revenues $5,000,000 $10,000,000 $14,000,000 $16,000,000 $12,000,000 $8,000,000
Less: Variable costs . $1,500,000 $3,000,000 $4,200,000 $4,800,000 $3,600,000 $2,400,000
Contribution $3,500,000 $7,000,000 $9,800,000 $11,200,000 $8,400,000 $5,600,000
Less: Fixed costs $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000
Less: Depreciation expense $3,400,000 $5,440,000 $3,264,000 $1,955,000 $1,955,000 $986,000
Net operating income before tax $(900,000) $560,000 $5,536,000 $8,245,000 $5,445,000 $3,614,000
Less: Tax expense $224,000 $2,214,400 $3,298,000 $2,178,000 $1,445,600
Net operating income after tax $(900,000) $336,000 $3,321,600 $4,947,000 $3,267,000 $2,168,400
Add: Depreciation expense $3,400,000 $5,440,000 $3,264,000 $1,955,000 $1,955,000 $986,000
operating cash flows $2,500,000 $5,776,000 $6,585,600 $6,902,000 $5,222,000 $3,154,400
7) Computation of non-operating (end-of-project) cash flows at the end of year 6:-
Year 6
Salvage value of equipment (net of tax) $2,400,000
Working capital released $4,000,000
Total non-operating cash flows $6,400,000
8) Timeline showing total cash flows for the venture:-
Year 0 1 2 3 4 5 6
Revenues $5,000,000 $10,000,000 $14,000,000 $16,000,000 $12,000,000 $8,000,000
Less: Variable costs . $1,500,000 $3,000,000 $4,200,000 $4,800,000 $3,600,000 $2,400,000
Contribution $3,500,000 $7,000,000 $9,800,000 $11,200,000 $8,400,000 $5,600,000
Less: Fixed costs $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000
Less: Depreciation expense $3,400,000 $5,440,000 $3,264,000 $1,955,000 $1,955,000 $986,000
Net operating income before tax $(900,000) $560,000 $5,536,000 $8,245,000 $5,445,000 $3,614,000
Less: Tax expense $224,000 $2,214,400 $3,298,000 $2,178,000 $1,445,600
Net operating income after tax $(900,000) $336,000 $3,321,600 $4,947,000 $3,267,000 $2,168,400
Add: Depreciation expense $3,400,000 $5,440,000 $3,264,000 $1,955,000 $1,955,000 $986,000
operating cash flows $2,500,000 $5,776,000 $6,585,600 $6,902,000 $5,222,000 $3,154,400
Initial investment $(21,000,000)
Non-operating cash flows $6,400,000
Total cash flow $(21,000,000) $2,500,000 $5,776,000 $6,585,600 $6,902,000 $5,222,000 $9,554,400
9) Computation of IRR and Payback period:-
Year 0 1 2 3 4 5 6
Revenues $5,000,000 $10,000,000 $14,000,000 $16,000,000 $12,000,000 $8,000,000
Less: Variable costs . $1,500,000 $3,000,000 $4,200,000 $4,800,000 $3,600,000 $2,400,000
Contribution $3,500,000 $7,000,000 $9,800,000 $11,200,000 $8,400,000 $5,600,000
Less: Fixed costs $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000
Less: Depreciation expense $3,400,000 $5,440,000 $3,264,000 $1,955,000 $1,955,000 $986,000
Net operating income before tax $(900,000) $560,000 $5,536,000 $8,245,000 $5,445,000 $3,614,000
Less: Tax expense $224,000 $2,214,400 $3,298,000 $2,178,000 $1,445,600
Net operating income after tax $(900,000) $336,000 $3,321,600 $4,947,000 $3,267,000 $2,168,400
Add: Depreciation expense $3,400,000 $5,440,000 $3,264,000 $1,955,000 $1,955,000 $986,000
operating cash flows $2,500,000 $5,776,000 $6,585,600 $6,902,000 $5,222,000 $3,154,400
Initial investment $(21,000,000)
Non-operating cash flows $6,400,000
Total cash flow $(21,000,000) $2,500,000 $5,776,000 $6,585,600 $6,902,000 $5,222,000 $9,554,400
Cumulative cash flows $(21,000,000) $(18,500,000) $(12,724,000) $(6,138,400) $763,600 $5,985,600 $15,540,000
IRR 15.82%
Payback period (in years) 3.89
10) IOS schedule of all projects including Project I:-
Project IRR
A 20.00%
B 18.00%
C 14.00%
D 12.00%
E 10.00%
I 15.82%
In above graph Each point shows the IRR of every project in sequention order as shown in table
11) Computation of firms corporate cost of capital:-
Corporate Cost of capital for new project would be as follows
Kd = 6.94%
Kr = 16.20%
Kp = 10.35%
Corporate cost of capital = Kd*Wd + Ke*We + Kp*Wp
Corporate cost of capital = 6.94%*26.0497% + 17.40%*69.4835% + 10.35%*4.4668%
Corporate cost of capital = 14.36%
12) Computation of discounted payback and NPV of project 1 at risk adjusted cost of capital:-
Risk adjusted cost of capital = Corporate cost of capital + Risk adjustment factor
Risk adjusted cost of capital = 14.36%+2%
Risk adjusted cost of capital = 16.36%
Year 0 1 2 3 4 5 6
Revenues $5,000,000 $10,000,000 $14,000,000 $16,000,000 $12,000,000 $8,000,000
Less: Variable costs . $1,500,000 $3,000,000 $4,200,000 $4,800,000 $3,600,000 $2,400,000
Contribution $3,500,000 $7,000,000 $9,800,000 $11,200,000 $8,400,000 $5,600,000
Less: Fixed costs $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000
Less: Depreciation expense $3,400,000 $5,440,000 $3,264,000 $1,955,000 $1,955,000 $986,000
Net operating income before tax $(900,000) $560,000 $5,536,000 $8,245,000 $5,445,000 $3,614,000
Less: Tax expense $224,000 $2,214,400 $3,298,000 $2,178,000 $1,445,600
Net operating income after tax $(900,000) $336,000 $3,321,600 $4,947,000 $3,267,000 $2,168,400
Add: Depreciation expense $3,400,000 $5,440,000 $3,264,000 $1,955,000 $1,955,000 $986,000
operating cash flows $2,500,000 $5,776,000 $6,585,600 $6,902,000 $5,222,000 $3,154,400
Initial investment $(21,000,000)
Non-operating cash flows $6,400,000
Total cash flow $(21,000,000) $2,500,000 $5,776,000 $6,585,600 $6,902,000 $5,222,000 $9,554,400
Present value factor @16.36% 1 0.86 0.74 0.63 0.55 0.47 0.40
Present value of cash flow $(21,000,000) $2,148,505 $4,265,989 $4,180,076 $3,764,958 $2,448,039 $3,849,295
Discounted accumulated cash flow $(21,000,000) $(18,851,495) $(14,585,506) $(10,405,430) $(6,640,472) $(4,192,433) $(343,139)
NPV $(343,139)
Discounted Payback period NA
13) In order to determine which project should be accepted we will compare the IRR of each project with the WACC of the organization and if the IRR is more than the WACC than in such case the project should be accepted and vice versa. The reason why projects with IRR lesser than WACC should be rejected is that these projects are not able to return the minimum required rate of return on the project which makes the project financially non feaslible. Following is the table showing which project must be accepted and which must not be accepted:-
WACC = 16.36% (for risky projects i.e. Project I)
WACC = 14.36% (for less risky projects i.e. Project A to E)
Project IRR Accepted or Rejected
A 20.00% Accept
B 18.00% Accept
C 14.00% Reject
D 12.00% Reject
E 10.00% Reject
I 15.82% Reject
As per the above analysis except project A and B all other projects must be rejected.
14) In case the project I would be of normal risk than we could have accepted that project also because the IRR of the project is 15.82% whereas the minimum required rate of return of less risky projects is 14.36% and this means the project would have yieldid positive NPV and therefore could be accepted. In order to validate the point following is the NPV calculation of the project using 14.36% as discounting factor:-
Year 0 1 2 3 4 5 6
Revenues $5,000,000 $10,000,000 $14,000,000 $16,000,000 $12,000,000 $8,000,000
Less: Variable costs . $1,500,000 $3,000,000 $4,200,000 $4,800,000 $3,600,000 $2,400,000
Contribution $3,500,000 $7,000,000 $9,800,000 $11,200,000 $8,400,000 $5,600,000
Less: Fixed costs $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000
Less: Depreciation expense $3,400,000 $5,440,000 $3,264,000 $1,955,000 $1,955,000 $986,000
Net operating income before tax $(900,000) $560,000 $5,536,000 $8,245,000 $5,445,000 $3,614,000
Less: Tax expense $224,000 $2,214,400 $3,298,000 $2,178,000 $1,445,600
Net operating income after tax $(900,000) $336,000 $3,321,600 $4,947,000 $3,267,000 $2,168,400
Add: Depreciation expense $3,400,000 $5,440,000 $3,264,000 $1,955,000 $1,955,000 $986,000
operating cash flows $2,500,000 $5,776,000 $6,585,600 $6,902,000 $5,222,000 $3,154,400
Initial investment $(21,000,000)
Non-operating cash flows $6,400,000
Total cash flow $(21,000,000) $2,500,000 $5,776,000 $6,585,600 $6,902,000 $5,222,000 $9,554,400
Present value factor @14.36% 1 0.87 0.76 0.67 0.58 0.51 0.45
Present value of cash flow $(21,000,000) $2,186,079 $4,416,507 $4,403,246 $4,035,324 $2,669,723 $4,271,285
NPV $982,162
Positive NPV above shows that the project must be accepted at the 14.36% rate of return.
16) Conclusion
Analysis of this project helps us in learning the procedure to evaluate a capital budgeting project using different financial tools. On the basis of analysis of this project we have came to a conslusion that Project I should not be accepted but there are other projects also available to the firm which can be accepted becuause the yeild offered by them is higher than that of the WACC of the firm.
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