Atlantic Land and Improvement Company (Alico) has hired you as a consultant to a
ID: 2804294 • Letter: A
Question
Atlantic Land and Improvement Company (Alico) has hired you as a consultant to advise them on a major purchase of a new Combine to speed up harvesting of crops. Part of your well-paid assignment includes developing the necessary financial data to support the decision. The Company's bonds have a par value of $1000 and are currently priced at $857.22 per 6% bond, paying interest annually and maturing in 11 years. The Company's stock has a Beta of 1.20, the return on the market is 15% and the risk free rate is 2%. The Company has no preferred stock outstanding, nor any foreseeable intention of issuing preferred stock. Its long-term targeted debt/equity ratio is 0.50. The Company's marginal tax rate is 40%. Alico wants you to evaluate the purchase of a new Combine for $333,000 with shipping and installation adding $15,000 to the capital cost. The new equipment will be depreciated over 5 years on a straight-line basis; it is expected that it will be sold for $30,000 at the end of 5 years Alico estimates that the new Combine will eliminate three workers, saving annual wages of $38,000 per worker Each question is worth 1 point except #6 and #7 which are each worth 2 points. Show your answers in whole dollars or percentages to 2 decimal places]. 1. What is the Company's after-tax cost of debt?.... 2. What is the Company's cost of common equity 3. What is the Company's weighted average cost of capital ?. 4. What is the total initial investment associated with the new Combine? 5. What is the net salvage value from the sale of the new Combine at the end of 5 years?.. 6. What is the net operating cash flow for the new Combine during each year 1-4? 7. Using the answers you calculated in questions 3-6, what is the NPV of the new Combine investment? Be sure to indicate whether the NPV is positive (+) or negative () 8. Do you recommend that Alico purchase the new Combine ("Accept") or not ("Reject"]? Your answer be supported by your answer to #7 must No credit will be given for an otherwise correct answer that is not based on questions. For example, you cannot get the correct answer to question 3 if you do not have the corre answers to questions 1 and 2 your answerfs) to supporting ct Portial credit may be given for an otherwise incorrect answer that is correctly calculated from an incorrect answer to a supporting question ative Problem; 12/12/2017Explanation / Answer
1) Calculation of YTM = Let take Approximate Ytm at 8%
So bond price at YTM 8% = $ 60 * PVAf (8%, 11) + $ 1000 * PVif (8%, 11)
For PVAf and PVif values refer PVaf and PVif table
= $60*7.13896 + $ 1000*0.42888
= $857.2176
I.e. equal to the current bond market price so YTM is 8%
After tax cost of Debt = ytm (1-t) where t is tax rate
= 8 %( 1-0.4)
= 4.8%
2) Cost of equity as per CAPM = Risk-free rate + Beta*Market risk premium
Market risk premium= Market Return - risk free rate
=2% +1.2*13%
=17.6%
3) Weighted average cost of capital = Cost of debt* weight of debt + cost of equity * weight of equity
= 4.8%* (0.6/1.6) + 17.6(1/1.6)
= 12.8%
Debt/ equity = 0.6 so Debt = 0.6, Equity = 1, Total = 1.6
4) Total initial investment for new combine = $ 333000 +$ 15000 =$ 348,000
5) Net salvage value = $ 30,000
6) Operating cash flows 1-4 = saving in wages*(1-t) + Tax saving on Depreciation
= $38,000(1-0.4) + $ 63,600 * 0.4
= $ 48,240
7) NPV of the project = 48,240*PVaf (12.8%, 5) + 30,000*PVIf (12.8%, 5) - $ 348000
For Pvaf and Pvif value refer PVAf and PVif Tables
= 48240*3.534 + 30000*0.548 - 348000
= - $ 161079.84
8) Reject the proposal as it has negative NPV.
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