Assignment: You are interested in proposing a new venture (Project I) to the man
ID: 2721704 • Letter: A
Question
Assignment: You are interested in proposing a new venture (Project I) to the management of your company. Pertinent financial information is given below.
Balance Sheet Data
Cash
2,500,000
Accounts Payable and Accruals
13,000,000
Accounts Receivable
24,500,000
Notes Payable
38,000,000
Inventories
40,000,000
Long-Term Debt
45,000,000
Preferred Stock
20,000,000
Net Fixed Assets
120,000,000
Common Equity
71,000,000
Total Assets
187,000,000
Total Liabilities &
Owners’ Equity
187,000,000
Last year’s sales were $200,000,000.
The company has 60,000 bonds with a 30-year life outstanding, with 15 years until maturity. The bonds carry an 8 percent semi-annual coupon, and are currently selling for $900.73.
You also have 100,000 shares of perpetual preferred stock outstanding, which pays a dividend of $6.80 per share. The current market price is $94.00.
The company has 10 million shares of common stock outstanding with a current price of $14.00 per share. The stock exhibits a constant growth rate of 9 percent. The last dividend (D0) was $.85.
Your firm does not use notes payable for long-term financing.
The firm’s target capital structure is 25% debt, 5% preferred stock, and 70% common equity. The firm does not plan to issue new common stock.
Your firm’s federal + state marginal tax rate is 35%.
The firm has the following investment opportunities currently available in addition to the venture that you are proposing:
Project
Cost
IRR
A
17,000,000
20%
B
21,000,000
18%
C
16,000,000
15%
D
28,000,000
10%
E
25,000,000
8%
All projects, including Project I, are assumed to be of average risk. 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. The resulting MACRS depreciation percentages for years 1 through 6, respectively, are 20%, 32%, 19%, 12%, 11%, and 6%. Your venture would require a capital investment of $16,000,000 in equipment, plus $900,000 in installation costs. The venture would also result in an increase in accounts receivable and inventories of $1,000,000 (value at the end of year 6). 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 would incur fixed costs of $1,000,000 per year, while the variable costs of the venture would equal 28 percent of revenues. You are projecting that revenues generated by the project would equal $6,500,000 in year 1, $13,500,000 in year 2, $16,000,000 in year 3, $15,000,000 in year 4, $11,000,000 in year 5, and $9,000,000 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.
1. Find the costs of the individual capital components:
a. long-term debt
b. preferred stock
c. retained earnings (use DCF approach)
2. Determine the weighted average cost of capital.
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 non-operating (terminal) cash flow at the end of year 6.
6. Draw a timeline that summarizes all of the cash flows for your venture.
7. Compute the IRR, payback, discounted payback, and NPV for Project I.
8. Prepare a report for the firm’s CEO indicating which projects should be accepted and why.
Cash
2,500,000
Accounts Payable and Accruals
13,000,000
Accounts Receivable
24,500,000
Notes Payable
38,000,000
Inventories
40,000,000
Long-Term Debt
45,000,000
Preferred Stock
20,000,000
Net Fixed Assets
120,000,000
Common Equity
71,000,000
Total Assets
187,000,000
Total Liabilities &
Owners’ Equity
187,000,000
Explanation / Answer
1. a. Cost of long term debt = Yield to maturity = YTM which is given by rate formula in excel =rate(nper,pmt,pv,fv) where nper = 15 years and in terms of semi annual periods, it is 30 , nper = 30.
pmt = coupon payment = 8% of 1000 = 80 (Anuual) = 40 (Semi annual)
PV = 900.73 and FV =1000
The semi annual rate = rate(30,40,-900.73,1000) = 4.6179%
Annual cost of debt = 4.6179% * 2= 9.24%
After tax cost of debt = 9.24%*(1-tax rate) = 9.24*(1-0.35) = 6%
1.b. The cost of preferred stock = Dividend / Market price = 6.80/94 = 0.07234 = 7.234%
1.c The cost of equity as per DCF = D1/P0 + g
D1 = dividend next year = 0.85*1.09 =0.9265
P0 = 14
g = 9% = 0.09
Cost of equity = 0.9265/14 + 0.09 = 0.1562 = 15.62%
2. The WACC = We* Re + Wpf * Rpf + Wd * Rd
We = 70% = 0.7
Re = 15.62%
Wpf = 5% = 0.05
Rpf = 7.234%
Wd = 25% = 0.25
Rd = 6%
Hence WACC = 0.7* 15.62 + 0.05*7.234 + 0.25*6 = 12.795 = 12.80%
Note: We have answered 4 sub-parts. Only 4 can be answered in one question. Kindly repost remaining as individual questions seperately for experts to answer
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