Sparta Inc. is considering an investment of $350,000 in an asset with an economi

Question

Sparta Inc. is considering an investment of $350,000 in an asset with an economic life of five years. The firm estimates that the annual cash revenues and expenses at the end of the first year will be $230,000 and $60,000, respectively. Both revenues and expenses will grow thereafter at an annual growth rate of 3 percent. Sparta will use the straight-line method to depreciate its assets to zero over five years. The salvage value of the asset is estimated to be $40,000 at that time. The one-time networking capital investment of $10,000 is required immediately and will be recovered at the end of the project. All corporate cash flows are subject to a 34% percent tax rate. If Sparta stocks have a beta of 2.0, the current risk-free rate is 4.5 percent, with a market risk premium of 5.2 percent. Sparta do have a bond outstanding with a before cost of debt of 7 percent. The debt ratio of Sparta is 40 percent. a. What is Sparta firm cost of capital ( ? b. What is the project

Explanation / Answer

a) Calculation of Cost of Capital:

For Equity: According to CAPM : Cost = rf + Beta (rm - rf)

Given, rf = 4.5%, Beta = 2, (rm - rf) = 5.2%

Cost of Equity = 4.5% + 2 (5.2%)

Cost of Equity = 14.90%

Calculation of After Tax Cost of Debt:

After Tax Cost of Debt = 0.07 x (1-0.34) = 4.62%

Proportion of Equity and Debt = 60% Equity and 40% Debt

Cost of Capital = (Cost of Equity x Proportion of Equity) + (Cost of Debt x Proportion of Debt)

Cost of Capital = (14.90 x 0.60) + (4.62 x 0.40)

Cost of Capital = 10.79%

b) Calculation of Total Net Flow From Assets for Each Year:

Year 1:

Year 2:

Year 3:

Year 4:

Year 5:

c) calculation of Payback and Discounted Pay Back Period:

Intial Investment = 350,000 + 10,000 = $360,000

Payback Period = 2 + 84,634 / 142,833 = 2.59 Years

Discounted Payback Period:

DPB = 3 + 18,671.24 / 105,033.67 = 3.18 Years

So, if Cutoff Period is 3 Years than According to Payback Period Approach, Asset should be Purchased because its Payback is less than Cutoff Payback.

According to Discounted Payback Period Approach, Asset should not be Purchased because its Payback is more than Cutoff Payback.

Amount($) Inflow 230,000 - Outflow 60,000 - Depreciation 70,000 Earning Before Tax 100,000 - Tax (34%) 34,000 Earning After Tax 66,000 + Depreciation 70,000 Net Inflow 136,000

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