BALANCE SHEET Cash 2,000,000 Accounts Payable and Accruals 18,000,000 Accounts R
ID: 2663987 • Letter: B
Question
BALANCE SHEETCash 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 year’s 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 semi-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 flotation costs, including market pressure, of 15 percent.
• The risk-free rate is currently 6 percent, and the rate of return on the stock market as a whole is 14 percent. Your stock’s 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 firm’s capital structure, rather than its book value.)
• The firm is currently using its assets at capacity.
• The firm’s management requires a 2 percent adjustment to the cost of capital for risky projects.
• Your firm’s federal + state marginal tax rate is 40%.
• Your firm’s 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 venture that 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%
Your venture 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, 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.
Compute the annual operating cash flows for years 1-6 of the project.
Explanation / Answer
Well... you have quite the capital budgeting problem here, complete with plenty of irrelevant and relevant cash flows. When you are trying to analyze cash flows in any capital budgeting problem you have to break them down into smaller parts otherwise you won't have a good place to start. There are 3 big groups to put your cash flows in that will organize this problem... 1. initial outlay 2. project life 3. terminal year.
Lets start with the initial outlay... These cash flows happen at year zero (or today) if we decide to do the project. They include things like initial investment, net working capital changes, and any other relevant cash flows that happen at time 0 of the project.
1. Initial Outlay
Initial Investment: -15,000,000 + -2,000,000 = -17,000,000
NWC change: -4,000,000
Total: -21,000,000
This next section is project life cash flows. These get a bit more tricky especially since we need to make sure that we don't use some of the irrelevant information given in the problem. Annual operating cash flows are going to include things like... revenue from the project, depreciation tax benefits, taxes we pay on project revenues, fixed/variable costs, etc. Since our revenues, depreciation, variable costs are changing every year we will need to calculate these cash flows year by year for years 1-6.
2. Project Life Cash Flows
Year 1
- Revenue: 5,000,000
- Depreciation benefit: 17,000,000 * MACRS rate 20% = 3,400,000
- Costs: -1,000,000 Fixed cost + -1,500,000 Variable costs (5M*.30) = -2,500,000
- taxes: 5,000,000 - 3,400,000 - 2,500,000 = -900,000 tax loss * .40 tax rate = +360,000 refund
Total year 1: 5,000,000 - 2,500,000 + 360,000 = 7,860,000
Year 2
- Revenue: 10,000,000
- Depreciation benefit: 17,000,000*MACRS rate 32% = 5,440,000
- Costs: -1,000,000 fixed cost + -3,000,000 variable cost (10M*.30) = -4,000,000
- taxes: 10,000,000 - 5,440,000 - 4,000,000 = 560,000 taxable income * .40 = -224,000
total year 2: 10,000,000 - 4,000,000 - 224,000 = 5,776,000
Year 3
- Revenue: 14,000,000
- Depreciation: 17,000,000*MACRS rate 19.2% = 5,440,000
- Costs: -1,000,000 Fixed Cost + -4,200,000 Variable cost (14M*.30) = -5,200,000
- taxes: 14,000,000 - 5,440,000 - 5,200,000 = 3,360,000 taxable income * .40 = -1,344,000
total year 3: 14,000,000 - 5,200,00 - 1,344,000 = 7,456,000
Year 4
- Revenue: 16,000,000
- Depreciation: 17,000,000*MACRS rate 11.52% = 1,958,400
- Costs: -1,000,000 fixed cost + -4,800,000 variable cost = -5,800,000
- taxes: 16,000,000 -1,958,400 - 5,800,000 = 8,241,600 * .40 = -3,296,640
total year 4: 16,000,000 - 5,800,000 - 3,296,640 = 6,903,360
Year 5:
- Revenue: 12,000,000
- Depreciation: 17,000,000*MACRS rate 11.52% = 1,958,400
- Costs: -1,000,000 fixed cost + -3,600,000 variable cost = -4,600,000
- taxes: 12,000,000 - 1,958,400 - 4,600,000 = 5,441,600 * .40 = -2,176,640
total year 5: 12,000,000 - 4,600,000 - 2,176,640 = 5,223,360
Year 6:
- Revenue: 8,000,000
- Depreciation: 17,000,000*MACRS rate 5.76%= 979,200
- Costs: -1,000,000 fixed cost + -2,400,000 variable cost= -3,400,000
- taxes: 8,000,000 - 979,200 - 3,400,000 = 3,620,800 * .40 = -1,448,320
total year 6: 8,000,000 - 3,400,000 - 1,448,320 = 3,151,680
I want to note a few things here... I assumed that the 2M installation costs were capitalized. Generally most installation costs can be capitalized but this isn't always the case. Your problem should have said whether or not these would be capitalized, but what are you going to do... With depreciation you will also noticed that a 5 year MACRS asset still gets some depreciation in year 6. This is because of the half year convention for personal property cost recovery. Without getting into too much detail you get a 1/2 years worth of depreciation after the last "class year" of the asset (it's just the way the IRS does it).
3. Terminal Year cash flows
We only have 2 terminal year cash flows here... the salvage value and NWC.
Salvage Value 4,000,000 ... Book value 0, so we have a taxable gain of 4,000,000 * tax (.40) = 1,600,000
Get cash of 4,000,000 - 1,600,000 taxes = +3,400,000 after tax salvage value
NWC will "come back" so we have an inflow of +4,000,000
year 6 terminal total: 4,000,000 + 3,400,000 = 7,400,000
Now have finally figured out all of the annual cash flows
year 0: -21,000,000
year 1: 7,860,000
year 2: 5,776,000
year 3: 7,456,000
year 4: 6,903,360
year 5: 5,223,360
year 6: 7,400,000+3,151,680 = 10,551,680
Alright this basically answers your question. Most of the bullets in your problem seem to hint that it may also want you to calculate the WACC. We could then use this rate to discount our cash flows and see if we have a positive or negative NPV. If you have any other questions or see a mistake feel free to email me at... nszucs@kent.edu
Hope this helps!
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