You have been assigned to a project to determine if a new investment should be m

Question

You have been assigned to a project to determine if a new investment should be made. Your company uses a capital structure of 30% debt and 70% equity. The debt pays 8.5% interest; the required return of the equity is 15%. The investment will be analyzed using a ten-year cash flow analysis. Here are the financial details: Year Expected sales Cost of Goods (%of sales) R&D expense 1 $1,000,000 40% $1,000,000 2 2,000,000 30% 500,000 3 3,000,000 25% 200,000 4 3,600,000 20% 200,000 5 4,000,000 20% 200,000 6 4,500,000 20% 200,000 7 5,000,000 20% 200,000 8 5,000,000 22% 100,000 9 4,000,000 24% 100,000 10 2,000,000 25% 50,000 Sales and marketing expenses are estimated to be 15% of sales. The corporate tax rate is 40% . The investment will be $4,000,000 at the start of the program (Year 0). For tax purposes, the investment will be amortized over 10 years. Administration costs are 4% of sales. The hurdle rate for the project is 1% over the company’s cost of capital. Calculate the IRR of this project and determine if it exceeds the hurdle rate or not. (Set up an Excel spreadsheet (Years 0-10) to do this calculation. Make sure you use the depreciation benefit in the tax calculation and the cash flow analysis.)

Explanation / Answer

SOLUTION :

WACC = .085(.6)*.3+.15*.7

12.03%

HURDLE RATE (12.03+1)

13.03%

Year

Initial investment

SALES

COGS

R&D

MARKETING EXP

INTEREST

amortisation

admin cost

EBT

EAT

EAT+DEPRECIATION

0

-4000000

-4000000

1

1000000

400000

1000000

150000

340000

400000

40000

-1330000

-798000

-398000

2

2000000

600000

500000

300000

340000

400000

80000

-220000

-132000

268000

3

3000000

750000

200000

450000

340000

400000

120000

740000

444000

844000

4

3600000

720000

200000

540000

340000

400000

144000

1256000

753600

1153600

5

4000000

800000

200000

600000

340000

400000

160000

1500000

900000

1300000

6

4500000

900000

200000

675000

340000

400000

180000

1805000

1083000

1483000

7

5000000

1000000

200000

750000

340000

400000

200000

2110000

1266000

1666000

8

5000000

1100000

100000

750000

340000

400000

200000

2110000

1266000

1666000

9

4000000

960000

100000

600000

340000

400000

160000

1440000

864000

1264000

10

2000000

500000

50000

300000

340000

400000

80000

330000

198000

598000

IRR

15.17%

IRR > Hurdle rate

WACC = .085(.6)*.3+.15*.7

12.03%

HURDLE RATE (12.03+1)

13.03%

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