Suppose y ou are evaluating a project for the Ultimate Golf Club, gauranteed to

Question

Suppose y ou are evaluating a project for the Ultimate Golf Club, gauranteed to correct the hacker's slice. You estimate the sales price of the Ultimate to be $400 and sales to be 1,000 units per year. You figure the project has a life of 3 years. Variable costs amount to $200 per unit and fixed costs are $120,000 per year. The project requires an initial investment of $165,000 which is depreciated straight-line over 5 years. The actual market value of the inital investment after year 3 is $45,000. Net working capital investment is $75,000. The tax rate is 34%.

The risk of this project is very similar to the company's other businesses. The company's capital structure is as follows:

Common Stock: 1 million shares outstanding, currently selling for $35 per share. The stock has a Beta of 1.2

Bonds: 20,000 bonds outstanding, $1000 face value for each bond, 7% annual coupon, 10 years to maturity, selling at 100% of par.

Market risk premium is 8% and risk free rate is 6%

a. What is the project's operating cash flow during its three-year life?

b. What is the project's total cash flows?

c. What is the firm's WACC?

d. What is the project's NPV?

e. What are the minimum operating cash flows needed for the NPV to be zero?

Explanation / Answer

a. What is the project's operating cash flow during its three-year life?

Depreciation per year = ($165,000-$45,000) /5 yrs =$24000 per year

b. What is the project's total cash flows?

c. What is the firm's WACC?

Using CAPM model Cost of Equity Ke = Rf + Beta(Rm-Rf) = 6%+ 1.2(8%-6%) = 8.4%

Cost of Bonds is YTM of Bonds . YTM of bon can be found from present value of bonds formulla as follows

Present value of Bond = Present value of principal +present value of all interest payments

Present value of bond is given as current selling price of $1000.

$1000 = $1000(PVIF, R%,10years) + $1000*7% ((PVIFA, R%,10years)

$1000 = $1000(PVIF, R%,10years) + $70 ((PVIFA, R%,10years)

By using trial and error method or spread sheet YTM is 7% .

Kd = 7%

WACC = KeWe +KdWd

=( 8.4%*0.64 ) + ( 7% *0.36)

= 7.89 %

.d. What is the project's NPV?

e. What are the minimum operating cash flows needed for the NPV to be zero?

Lets assume operating cashflows to x.

NPV = 0

0 = Present value of cash outflow - present value of Cash inflows

0= ($240,000) Year 0+Year 1 (x*1/1.0789) + Year 2 (x*(1/1.0789)^2) + Year 3  (x*(1/1.0789)^3) +Year 3 ($75,000+$29,700) *(1/1.0789)^3

= ($240,000) + 09269x +0.8591X + 0.7963x +$104,700*07963

$240,000 = 2.5822x + $83,369

2.5822x = $156,631

X = $60,658

Minimum operating cash flows needed for the NPV to be zero is $60,658.

Operating cash flows Cash flow per year$ Revenue ($400*1000 units)                  400,000 -Expenses (excluding depreciation) Variable Cost ($200*1000 units)                  200,000 Fixed Expenses                  120,000 Profits before depreciation and taxes                   80,000 -depreciation                   24,000 Net profits before taxes                   56,000 less: taxes 34%                   19,040 Net profits after taxes                   36,960 +depreciation                   24,000 Operating cash inflows                   60,960

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