Question

University Inn is planning to replace its washing machine, a major capital expenditure for this year. General Manager, John Adams, is reviewing the follow information for decision making. The purchase price of the new washing machine at time 0 = $10,000 Life of the new machine is 10 years (salvage value at the end of year 10 = $0) The new machine is expected to make $25,000 in laundry revenues each year. The expense for operating and maintaining laundry services is $23,000 each year.

Mr. Adams knows the required rate of return for similar capital investment is 24% (KE). University Inn will finance the purchase by using 50/50 mix of debt and equity. The cost of debt (KD) to the firm is 10%. University Inn’s marginal tax rate is 40%. Mr. Adams needs your assistance to determine the following for his purchase decision:

Required: a. weighted average cost of capital (KA)

b. operating cash flow for 10 years (OCFt)

c. Net Present Value (NPV) using Present Value Annuity Factor (PVAn=10,k=12)

Should Mr. Adams make this purchase? Why?

Answer 1

1. WACC = Weight of Debt * Cost of Debt * (1 - Tax) + Weight of Equity * Cost of Equity

WACC = 0.50 * 10% * (1 - 40%) + 0.50 * 24%

WACC = 15%

2.

Operating cash Flow = (Revenue - Operating Costs - Depreciation - Interest) * (1 - Tax) + Depreciation

Operating cash Flow = (25000 - 23000 - 1000 - 500) * (1 - 0.40) + 1000

Operating cash Flow = 1300 per year

3. NPV = Operating Cash Flow * PVAF(10,12) - Cash Outflow

NPV = 1300 * 5.6502 - 5000

NPV = $2345.29

As the NPV is positive the adams can purchase the equipment.