You\'ve been hired fresh off your MBA as a financial consultant for an organizat

Question

You've been hired fresh off your MBA as a financial consultant for an organization. The new now for-profit publicly traded firm that is the market leader in kindney dialysis systems (KDSs). The company is looking at stettung up a manufacturing plant overseas to produce a new line of KDSs. This is a five year project.

The company bought some land three years ago for $6 million in anticipation of using it as a toxic dump site for waste chemicals instead. If the land were sold today, the nexxt proceeds woudl be 6.4 million after taxes. The company wants to build its new manufacturing plant on this land: the plant will cost 9.8 million to build. The following market data on the company's securities are current:

Debt $25,000 of 6.5 percent coupon bonds outstanding, 20 years to maturity, selling for 96% of par: the bonds have a $1000 par value each and make semiannual payments.

Common stock: 400,000 share outstanding, selling for $89 per share; the beta is 1.20

Preferred stock 35,000 shares at 6.5% preferred stock outstanding, selling for $99 per share; the preferred have a $100 par value each.

Market: 8% expected market risk remium; 5.20% rish-free rate.

The company's taxe ratre is 34 percent. The project requires $825,000 in initial net working capital investment to get operational and will be recovered in the final year of operation.

The manufacturing plant has an eight year life and the company uses straight line depreciation. At the end of the project (i.e. the end of year 5), the plant can be scrapped for 1.25 million.

The company will incur $2,100,00 in annual fixed costs. The plan is to manufacture 11,000 KDSs per year and sell them at $10,000 per machine, the variable production costs are $9,000 per KDS.

The company's president want you to throw all you calculations, all your assumptions, and everything else into a report for the CFO: all she want to know is what the KDS projects NPV is.

Please so NPV work in excel.

Explanation / Answer

To calculate cost of capital: Cost of debt (1000*96%)=((6.5%/2*1000)*(1-(1+r)^-40)/r)+(1000/(1+r)^40) So, semi-annual r=0.03435--ie. 3.435% So annual r = 3.435%*2= 6.87% After-tax cost of debt=6.87%*(1-34%)= 4.53% Cost of Equity as Per CAPM RFR+(Beta*Market Risk Premium) 5.20%+(1.2*8%)= 14.80% Cost of preferred stock $ Dividend/Current stock price (6.5%*100)/99= 6.57% So, WACC= (After-tax Cost of Debt*Wt.of debt)+(Cost of Equity*Wt.of Equity)+(Cost of Preferred stock*Wt. of preferred stock) ie. Type of capital Market Value Wt. to total value Cost Wt. *Cost Debt 25000 0.000639 4.53% 0.0000 Common stock 35600000 0.909904 14.80% 0.1347 Pref. stock 3500000 0.089457 6.57% 0.0059 39125000 1 WACC= 0.1406 or 14% Table-1 Calculation of annual operating cash flows Sale value(11000*10000) 110000000 Less:Annual fixed costs 2100000 Less: Variable prodn. Costs(9000*11000) 99000000 Less: Depn.(9800000/8) 1225000 Before-tax opg. Costs 7675000 Tax at 34% 2609500 After-tax opg. Income 5065500 Add Back: depn. 1225000 After-tax annual opg. Cash flow 6290500 Table-2---- After-tax Plant salvage Cost to build 9800000 Less:Acc. Depn. 6125000 Carrying value 3675000 Sale Value 1250000 Loss on sale 2425000 Tax saved on loss(2425000*34%) 824500 So, after-tax cash salvage(1250000+824500) 2074500 NPV calculations Opportunity cost of land -6400000 Cost to build -9800000 NWC introduced -825000 PV of 5 yr. opg. Cash flows(as per Table-1) (6290500*3.43308) 21595790 PVOA F 14%,5 yrs.) NWC recovered 825000*0.51937 428480 PV F 14%,5 yrs.) After-tax Plant salvage (as per Table-2) 2074500*0.51937 1077433 Depn. Tax shields lost on early scrapping of plant Yr.6--1225000*34%*0.45559 -189753 Yr.7--1225000*34%*0.39964 -166450 Yr.8--1225000*34%*0.35056 -146008 Net Present Value of the project 5574492

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