A firm is considering undertaking a capital investment project. The firm is plan
ID: 2755138 • Letter: A
Question
A firm is considering undertaking a capital investment project. The firm is planning on producing a new line of oversize tennis rackets. The additional equipment needed to produce the new rackets would cost $402,215 initially. This amount will be depreciated straight line to a zero salvage value over a 5 year life. The company has already spent $145,000 on an extensive marketing survey that yielded encouraging results for their project. Also, if the firm decides to make the new rackets they will be unable to sell $192,000 (after tax value) of equipment they had planned on selling. The project will require an additional $34,000 in working capital at the start of the project. The increased working capital will not be needed after year 5.
The project’s marginal operating revenues and expenses before taxes are given in the following table (the project has a five year life):
(Marginal)
Year 1
Year 2
Year 3
Year 4
Year 5
Sales Revenue
$399,412
$405,615
$422,000
$397,555
$289,410
Variable Costs
20% of revenue
20% of revenue
20% of revenue
20% of revenue
20% of revenue
Fixed Costs
$89,500
$89,500
$89,500
$89,500
$89,500
Depreciation
?
?
?
?
?
All revenues and expenses are on a cash basis. The firm has a marginal tax rate of 34% and an average tax rate of 25%. The required return on equity is 10.250%, and the firm’s pre-tax cost of debt is 4.167%. The firm employs a 46% debt to capital ratio. The firm considers this project to be about the same level of risk as the typical project for the firm.
Watch your rounding, excessive rounding will result in incorrect answers. Round your final answers to two decimal places but do not round any intermediate calculations or variables to less than 4 decimal places. You will not get credit if you do not show your work with the appropriate formulas.
a. What is the firm’s WACC? (Show your work.) (1 point)
b. What is the project’s NPV? (For full credit you must show your work by providing a timeline of the initial cost and the calculation for each year’s Cash Flow from Assets, and also show the NPV equation and the solution.) (4 points)
c. What is the project’s IRR? (Show the IRR equation and provide the calculator solution.) (1 point)
d. What is the project’s payback? (1 point, show your work.)
e. Should the firm take the project? Indicate why. If they do by how much should shareholder wealth change? (1 point)
Please show work.
(Marginal)
Year 1
Year 2
Year 3
Year 4
Year 5
Sales Revenue
$399,412
$405,615
$422,000
$397,555
$289,410
Variable Costs
20% of revenue
20% of revenue
20% of revenue
20% of revenue
20% of revenue
Fixed Costs
$89,500
$89,500
$89,500
$89,500
$89,500
Depreciation
?
?
?
?
?
Explanation / Answer
(‘a) WACC-
Debt to Capital = 46 %
Hence Debt = 46 % in Total Capital
Equity = 54 % (100%-46 %) in Total Capital
Cost of Equity = 10.25 %
Pre Tax Cost of Debt = 4.167
Post Tax Cost of Debt = 4.167 x (1- Marginal Tax Rate)
Post Tax Cost of Debt = 2.75 %
WACC = (Weight of Debt x Post Tax Cost of Debt ) + (Weight of Equity x Cost of Equity)
WACC = (46 % x 0.0275) +( 54 % x 0.1025)
WACC = 1.2650+5.350
WACC = 6.80
(‘b) Marginal Tax rate should be used to evaluate the project because average tax rate is the only reflection of the difference between the accounting and tax profits.
Statement Showing Calculation of Cash Flow After Tax
Particulars
Year 1
Year 2
Year 3
Year 4
Year 5
Sales
399,412
405,615
422,000
397,555
189,410
Variable Cost
79,882
79,882
79,882
79,882
79,882
Fixed Cost
89,500
89,500
89,500
89,500
89,500
Depreciation
80,443
80,443
80,443
80,443
80,443
Amortisation
29,000
29,000
29,000
29,000
29,000
Operating Income
120,587
125,549
138,657
119,101
-47,415
Tax @ 34 %
40,999
42,687
47,143
40,494
-16,121
Net Income
79,587
82,862
91,514
78,607
-31,294
Add: Depreciation and Amortisation
109,443
109,443
109,443
109,443
109,443
Cash Flow After Tax
189,030
192,305
200,957
188,050
78,149
Working Capital Release
-
-
-
34,000
Cash Flow
189,030
192,305
200,957
1880,50
112,149
Present Value Factor @ 6.8 %
0.936
0.877
0.821
0.769
0.720
Discounted Cash Inflow
176,995
168,597
164,964
144,540
80,712
Present Value of Cash Inflow = 735,807
Cash Outflow = Investment + Investment in Working Capital
Cash Outflow = 402,215 + 34000
Cash Outflow = 436,215
NPV = Present Value of Cash Inflow – Cash Outflow
NPV = $299,592
(‘c) IRR-
IRR is rate at which NPV =0
By using trial and error method
We get
NPV at 31 % = 2455.75
NPV at 32 % = -5342.75
Hence IRR will be between 31 and 32 %
By interpolation we get
IRR = 31.31 %
(‘d) Payback Period (Simple)
At the end of 2nd year cumulative cash inflow= 381,335
At the end of 3rd year Cumulative cash Inflow = 582,292
Cash Outflow = 436,215
Hence Payback period will be between 2nd and 3rd year
By interpolation we get
Payback period = 2 + (436215-381335)/(582292-436215)
Payback period = 2.36 year
(‘e) Frim Should take project
Because it is generating positive Net Present Value of $ 299,592
And IRR of the project is greater than WACC
If the firm take project shareholders wealth will be increased by $299,592
Particulars
Year 1
Year 2
Year 3
Year 4
Year 5
Sales
399,412
405,615
422,000
397,555
189,410
Variable Cost
79,882
79,882
79,882
79,882
79,882
Fixed Cost
89,500
89,500
89,500
89,500
89,500
Depreciation
80,443
80,443
80,443
80,443
80,443
Amortisation
29,000
29,000
29,000
29,000
29,000
Operating Income
120,587
125,549
138,657
119,101
-47,415
Tax @ 34 %
40,999
42,687
47,143
40,494
-16,121
Net Income
79,587
82,862
91,514
78,607
-31,294
Add: Depreciation and Amortisation
109,443
109,443
109,443
109,443
109,443
Cash Flow After Tax
189,030
192,305
200,957
188,050
78,149
Working Capital Release
-
-
-
34,000
Cash Flow
189,030
192,305
200,957
1880,50
112,149
Present Value Factor @ 6.8 %
0.936
0.877
0.821
0.769
0.720
Discounted Cash Inflow
176,995
168,597
164,964
144,540
80,712
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.