ABC Enterprise is considering the purchase of a new assembly line, costing $300,
ID: 2653140 • Letter: A
Question
ABC Enterprise is considering the purchase of a new assembly line, costing $300,000. The new assembly line has a 5-year tax life and will be depreciated under straight-line. The firm estimates that in 4 years the assembly line can be salvaged for $40,000. For the next 4 years the new assembly line will increase output and thereby raises sales by $15,000 per year and will reduce production expenses by $5,000 per year. The firm also needs an initial decrease in net working capital of $20,000. Assume that 10 ABC’s tax rate is 34% and ABC Enterprise has the following information on its equity and bonds:
Common stock: 2 million shares outstanding, currently selling for $30 per share. ABC Enterprise expects to pay dividend of $3.00 next year and the dividend growth rate is expected to be 5%.
Bonds: 80,000 bonds outstanding, $1,000 face value for each bond, 7% coupon with 10 years to maturity, and selling for $1,150.00. The bonds pay coupons semiannually.
ABC Enterprise plans to raise the funds needed to purchase the assembly line by issuing new common stocks and bonds. The flotation costs of the new common stock would be 8% of the amount raised. The flotation costs of the new bonds would be 4% of the proceeds.
(a) (13 points) What is the WACC of ABC Enterprise? (b) (10 points) What is the NPV of the project?
Explanation / Answer
(‘1) Calculation of WACC of ABC
Existing cost of common Stock
Ke = D1/ P0 + G
Ke = 3/30 + 0.05
Ke = 15 %
Cost of additional common stock issued
Ke = 3/(30—2.4) + 0.05
Ke = 15.87 %
Cost of Bond – It is nothing but YTM
Price = Present Value of All Coupon payments received in future + Present value of FV
Price = 35[ ( 1+r)-1 + (1+r)-2 + (1+r)-3 + ……. + (1+r)-20 ] + 1000 x (1+r)-20
Otherwise approx. YTM can be calculated with this formula
Where Coupon payment= $ 35, Face Value= 1000, Price = 1150, n = 20 periods of coupon
YTM = Coupon Payment +( Face Value- Price)/n
(Face Value + Price )/2
After calculating we get
YTM = Kd = 5. 07%
Cost of additional fund raised through bond= 5.63 % in this case price will be reduced by floatation cost price= 1104 (1150 x 96 % )
Existing Weight of Different Component of Capital
Component
Number
Market Price
Total Market Value
Weight
Common Stock
2000,000
30
60, 000,000
39.47 %
Bonds
80,000
1150
920,00,000
60.53 %
152000,000
In the absence of specific information it is assumed additional fund will be raised in same proportion.
After issue of additional fund WACC of ABC will be weighted average marginal cost of capital.
Component
Cost
Weight
WACC
Common stock
15.87
39.47
6.26
Bond
3.72 ( 5.63 x 0.66 ) After tax cost of debt
60.53
2.25
WACC
8.51
WACC of ABC = 8.51 %.
( Note – Cost of existing common stock and existing debt is less than new cost of these sources used for additional fund. WACC may be calculated by calculating weight of old sources and new sources.. But as NPV is asked for new machinery hence that WACC will be irrelevant. )
(‘2) NPV of Project
Year 1
Year 2
Year 3
Year 4
15,000
15,000
15,000
15,000
5,000
5,000
5,000
5,000
(60,000)
(60,000)
(60,000)
(60,000)
(40,000)
(40,000)
(40,000)
(40,000)
(40,000)
(40,000)
(40,000)
(40,000)
60,000
60,000
60,000
60,000
20,000
20,000
20,000
20,000
PV of Cash Inflow = 20,000 x AF @ 8.51 % for 4 year
PVCIF= 20,000 x 3.274
PVCIF= 65,480
PV of Salvage value after tax
Sale Value
40,000
Cost ( 300,000- 240,000)
(60,000)
Net Loss
(20,000)
PV Factor
0.7213
PV of Loss
(14,426)
NPV= PV of Cash Inflow – Initial cost = PV of salvage value
NPV= 65,480-300000-14426
NPV= $ -248946
Note- Tax saving on operating loss is ignored as it is actually not contributing a cash inflow.
However it may be considered. In that cash operating cash inflow = 20000+ (40000 x0.34)
Operating cash flow= 33,600
Component
Number
Market Price
Total Market Value
Weight
Common Stock
2000,000
30
60, 000,000
39.47 %
Bonds
80,000
1150
920,00,000
60.53 %
152000,000
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