Kentucky Hardware Company (KHC) is considering an investment project that requir
ID: 2787375 • Letter: K
Question
Kentucky Hardware Company (KHC) is considering an investment project that requires a new machine for producing special tools. This new machine costs $1,000,000 and will be depreciated over 10 years on a straight-line basis toward zero salvage value. KHC paid a consulting company $50,000 last year to help them decide whether there is sufficient demand for the special tools. In addition to the investment on the machine, KHC also invests $30,000 in net working capital. The company pays $45,000 in interest expenses annually. KHC has estimated the performance of the new machine and believes that the new machine will produce $350,000 per year in sales, $130,000 per year in cost of goods sold, and $25,000 per year in administrative expenses.
In order to get an estimate of cost of capital, KHC collect the following information. KHC has 310,000 shares of common stock outstanding, 15,000 shares of preferred stock outstanding, and 8,000 issues of corporate bond outstanding. The bonds have face value $1,000 and coupon rate 6%. The bonds make semiannual coupon payments, have 25 years to maturity, and sell for 131.423% of par. The common stock sells for $56 per share and has a beta of 1.05. KHC’s next common stock dividend is expected to be $2.80 per share, and the common stock dividend is expected to grow at 7.7% indefinitely. The preferred stock sells for $72 per share and pays $4.5 annual dividend. The market risk premium is 8%, T-bills are yielding 4.5%, and KHC’s tax rate is 25%.
Use the above information to answer Questions 1 - 17.
Should KHC include consulting fee, $50,000, in estimating project's cash flows?
Yes.
No.
a.Yes.
b.No.
Kentucky Hardware Company (KHC) is considering an investment project that requires a new machine for producing special tools. This new machine costs 1,000,000 and will be depreciated over 10 years on a straight-line basis toward zero salvage value. KHC paid a consulting company s50,000 last year to help them decide whelher there is sufficient demand for the special tools. In addiion to the investment an the machine, KHC also invests $30,000 in net working capital. The company pays $45,000 in interest expenses annual KHC has estimated th pa o manca ofhe e machine and belia as hat he new machine wil pr duaS350 peryaa insas.S130, 00 re in cost of goods d and 00 rnir na ministrati a penses. In order to get an estimate of cost of capital, KHC collect the following information. KHC has 310,000 shares of common stock outstanding, 15,000 shares of preferred stock outstanding and 8,000 issues of corporate bond outstanding. The bonds have face value $1 000 and coupon rate 6 The bonds make ser la nual coupon payments have 25 y a to maturity and sell or 31 423% of par The common stock sels r $56 per share and has a beta o 1 05 KHC's nex c mmon stock dl and is B pected to bB $2 80 per share and the common stock dividend is expected to grow at 7.7% indefinitely. The referred stock sells for S72 per share and pays S4 5 annual di dend. The mane risk premium is 8%. T tils are e ding 4.5% and H 'star rate s 25%, Use the above information to answer Questions 1-17 Should KHC include consulting fee, $50,000, in estimating project's cash flows? O a. Yes. Ob No h lows?Explanation / Answer
1. Should KHC include consulting fee, $50,000, in estimating project's cash flowings?
No, Since the cash flow has already taken place before the start of the project (sunk cost). It should not be considered in estimating the cash flows.
2. Should Interest expense be included in the cash flows?
No, since the question does not explicitly mention that the interest payment is due to the debt taken to implement the project, It would mean that the company has been paying interest expense before the start of the project. So, it should not be considered in the cash flows.
3. Investment at the start of the project = Machine Cost + Net Working capital
= 1,000,000 + 30,000
= 1,30,0000
4. Cash flows from the project in Year 10, First we have to calculate the book profit from the project,
Gross Profit = Revenue-COGS = 350,000-130,000-25,000 = 195,000
Depreciation = 100,000
Profit before Tax = 170,000-100,000 = 95,000
Tax Expense = 25% * 70,000 = 23,750
Profit After Tax = 71,250
Non-Cash expenses = Depreciation = 100,000
Changes in Working Capital = 30,000 (Since working capital will be liquidated after the project)
Total Cash flows = 71,250+100,000+30,000 = 201,250
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