Question

meo foods inc. currently has a debt-equity ratio of 25% and maintained a constant level of debt in the recent past. the firm can borrow at a 10% interest rate, and is in the 40% tax bracket. its shareholders require an 18% return. meo is planning to expand capacity. the equipment to be purchased for $15 million would last 3 years, and generate after-tax free cash flows of $5, $8 and $10 million, respectively. meo has arranged a $6 million debt issue to partly finance the expansion. under the loan, the company would pay 10% annually on the outstanding balance. the firm would also make principal repayments of $2 million at the end of each year, completely retiring the issue at the end of year 3. determine whether meo foods should proceed with the expansion?

Answer 1

weighted average cost of capital = weight of debt * cost of debt * ( 1 - tax rate ) + weight of equity * cost of equity

= 0.25 * 10 * ( 1- 0.4) + 0.75* 18 = 14.50%

Particulars	Year 1	Year 2	Year 3	Total
Balance on loan	6	4	2
Amortisation of loan	2	2	2
Interest	0.6	0.4	0.2
Tax on Interest	0.24	0.16	0.08
Free cash flow	5	8	10
Free cash flow + Tax on Interest	5.24	8.16	10.08
Discounting Factor ( 1 / ( 1 + r)^n	0.873362445	0.762761961	0.666167652
Present value	4.576419214	6.224137602	6.714969928	17.51552674

Net present value = 17.52 - 15 = 2.52

As the NPV is positive we can accept the project.