Question

1. Anyidado Ltd. is considering a new project that complements its existing business. The machine required for the project costs GHS3.4 million. The marketing department predicts that sales related to the project will be GHS1.9 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are predicted to be 30 percent of sales. Anyidado Ltd. also needs to add net working capital of GHS250,000 immediately. The corporate tax rate is 35 percent.
New investment projects in Anyidado Ltd. have the same risk as the firm’s typical project. The has 8 million shares of common stock outstanding, 0.5 million shares of 6 percent preferred stock outstanding, and 100,000 9 percent semi-annual bonds outstanding, par value GHc1,000 each. The common stock currently sells for GHS 32 per share and has a beta of 1.15, the preferred stock currently sells for GHS 67 per share, and the bonds have 15 years to maturity and sell for 91 percent of par. The market risk premium is 10 percent, and T-bills are yielding 5 percent.
Required:
(a) What is the cost capital that should be used to assess the viability of the project?    (b) Using the NPV rule, should the project be accepted?    

Answer 1

a) Since the project is of same risk nature as that of the firm, we will use WACC for the calculation of NPV.

b) For b, I am assuming working capital would not be released at the end of the project.

So, NPV then = -227,332.85. Negative NPV mean this project would erode firm value and hence should be rejected.

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{In case, if Working capital was released at the end of the project, it would have been rejected again.

But NPV then would have been -76,342.11

}