Question

Johnny Wellington, an entrepreneur who wants to engage in a short term business project, comes to you for advice. As an expert in capital budgeting, Johnny wants you to study the feasibility of the project. In particular, he needs your help to forecast the upcoming cash flows the project is going to require and generate throughout its life. After a few meetings with Johnny and his business partners, you suggest that a pilot run be conducted. Upon completion of the pilot run at the end of year 1, Johnny and his associates can choose either to continue with the project or terminate it. You forecast that this project will generate cash flows for 4 years after the pilot run if Johnny decides to further proceed. The pilot run costs $1.0 million to start and if they decide to continue with the project after this pilot run, an additional investment cost amounting to USD1.6 million will be incurred at the end of year 1. The investment cost of USD1.6 million will be fully depreciated on a straight line basis over the life of the project with no scrap value at the end. If the outcome from the pilot run is positive, Johnny can launch the project in full scale at the end of year 1. Revenues, variable costs and fixed costs for years 2 through 5 are estimated to be as follows:

Years 2-5

Revenues USD 7 mil / year

Variable Costs USD 3 mil / year

Fixed Costs USD1.8 mil / year

However, if the outcome from the pilot run is not encouraging and the team decides to launch the project in full scale, the following estimates are obtained:

Years 2-5

Revenues USD 4.05 mil / year

Variable Costs USD 1.735 mil / year

Fixed Costs USD 1.8 mil / year

You project that the pilot run has a 60% chance of being successful (i.e. outcome is positive). To finance the pilot run and the full-scale project, Johnny and his associates decide to use 50% debt and 50% equity. An investor who is Johnny’s high school buddy, Barry Lawson, agrees to enter into a special arrangement in which 5-year promissory notes with a face value of USD1000 per note will be sold to Barry at a price of USD694.11 per note. These notes do not make intermediate interest payments. (Note: Consider annual compounding for the promissory notes.) You gather some market data to work out the equity beta for the project and it is determined to be 1.50. Further, the market return and T-bill rate are 11 % and 4%, respectively. Assume the T-bill rate is an appropriate proxy for the risk-free rate of return. Profits and losses from the project will be taxed at a rate of 34%. Assume the Capital Asset Pricing Model (CAPM) is valid.

Required

a) Determine the after-tax cost of debt. (1 mark)

b) Determine the cost of equity. (1 mark)

c) Calculate the weighted average cost of capital for the project.

d) What is the present value of the cash flows at year 1 if outcome from the pilot run is positive and the team decides to launch the project in full scale? Ignore your answer in part c) and use 10% as the appropriate discount rate. [Hint: Consider cash flows from year 1 onwards]

e) What is the present value of the cash flows at year 1 if outcome from the pilot run is negative and the team decides to launch the project in full scale? Ignore your answer in part c) and use 10% as the appropriate discount rate. [Hint: Consider cash flows from year 1 onwards]

f) Should the project be implemented today (i.e. year 0)? Provide relevant and supporting calculations. Again, ignore your answer in part c) and use 10% as the appropriate discount rate. Show all steps and give proper explanations.

Answer #1

1. Consider a project with free cash flows in one year of
$132,824 in a weak market or $171,945 in a strong market, with
each outcome being equally likely. The initial investment required
for the project is $90,000, and the project's unlevered cost of
capital is 10%. The risk-free interest rate is 12%. (Assume no
taxes or distress costs.)
a. What is the NPV of this project?
b. Suppose that to raise the funds for the initial investment, the
project...

A company is considering a new project. The project will
generate $200,000 in revenues and $110,000 in operating costs each
year for the next 5 years. It would require an additional
investment of $150,000 to be depreciated to a zero book value on a
straight line basis over 5 years. The investment has a salvage
value of $20,000. The tax rate is 40%. At the end of year 5, there
is a $10,000 return of networking capital. Determine the annual...

A proposed investment has a project life of four years. The
necessary equipment will cost of $1,200, and have a useful life of
4 years. The cost will be depreciated straight-line to a zero
salvage value, but will have a market worth $500 at the end of the
project’s life. Cash sales will be $2,190 per year for four years
and cash costs will run $670 per year. Fixed cost is $176 per year.
The firm will also need to...

Firm A’s new project needs $325,000 for new fixed assets (long
term assets), $160,000 for additional inventory and $35,000 for
additional accounts receivable. This is a five year project. Use
straight line depreciation approach to calculate the depreciation
expenses. By the end of the fifth year, the value of the fixed
assets = 0. However, the market value of the assets = 25% of their
original cost. At the end of the project, the net working capitals
tend to return...

A capital budgeting project is being considered for
implementation. The asset is a 3-year MACRS class asset with a
four-year project life. The cost of the asset, and the first year
revenue and operating cost projections are provided in the table
below:
Price of Asset
$280,000.00
Freight / Installation
$20,000.00
Depreciation Schedule:
Year 1
$99,000.00
Year 2
$135,000.00
Year 3
$45,000.00
Year 4
$21,000.00
Salvage Value
$30,000.00
Increase in NWC
$25,000.00
Revenues from project
$260,000.00
Operating Costs (excluding depreciation)
$115,000.00...

25.
Red Royal Banking is evaluating the medical clinic project, a
2-year project that would involve buying equipment for 66,000
dollars that would be depreciated to zero over 2 years using
straight-line depreciation. Cash flows from capital spending would
be $0 in year 1 and 8,000 dollars in year 2. Relevant annual
revenues are expected to be 108,000 dollars in year 1 and 108,000
dollars in year 2. Relevant expected annual variable costs from the
project are expected to be...

Red Royal Packaging is evaluating the medical clinic project, a
2-year project that would involve buying equipment for 36,000
dollars that would be depreciated to zero over 2 years using
straight-line depreciation. Cash flows from capital spending would
be $0 in year 1 and 23,000 dollars in year 2. Relevant annual
revenues are expected to be 60,000 dollars in year 1 and 60,000
dollars in year 2. Relevant expected annual variable costs from the
project are expected to be 18,000...

Which of the following statements is CORRECT?
a. A sunk cost is any cost that must be
expended in order to complete a project and bring it into
operation.
b. A sunk cost is a cost that was incurred and
expensed in the past and cannot be recovered regardless of whether
the project is accepted or rejected.
c. A sunk cost is any cost that was expended in
the past but can be recovered if the firm decides not to go forward
with...

Amazon Corporation is considering two long-term capital
investment proposals. Relevant data on each project are as
follows.
Project Milo
Project Otis
Capital investment
$196,000
$223,000
Annual net cash flows:
Year
1
64,644
64,748
2
55,388
64,748
3
52,459
64,748
4
49,686
64,748
5
47,235
64,748
Total
$ 269.412
$323,740
Other information: The company’s minimum rate of return is the
company’s cost of capital which is 12%. Assume cash flows occur
evenly throughout the year.
Instructions:
Compute the following...

White Mountain Banking is evaluating the pet care center
project, a 2-year project that would involve buying equipment for
52,000 dollars that would be depreciated to zero over 2 years using
straight-line depreciation. Cash flows from capital spending would
be $0 in year 1 and 23,000 dollars in year 2. Relevant annual
revenues are expected to be 96,000 dollars in year 1 and 96,000
dollars in year 2. Relevant expected annual variable costs from the
project are expected to be...

ADVERTISEMENT

Get Answers For Free

Most questions answered within 1 hours.

ADVERTISEMENT

asked 22 minutes ago

asked 51 minutes ago

asked 59 minutes ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 2 hours ago

asked 2 hours ago

asked 2 hours ago

asked 2 hours ago

asked 2 hours ago

asked 2 hours ago