Jamnic Digital Automotive manufactures a variety of electronic products. The com
ID: 2749964 • Letter: J
Question
Jamnic Digital Automotive manufactures a variety of electronic products. The company is considering introducing its most exciting product; a new digital instrument panel for customized classic cars. This panel allows the car owner to customize the complete set of instruments for the vehicle. Output display may be analog or digital, with many styles of display using apps that may be purchased, downloaded, and installed with a micro SD card. Your analysts have provided you with the following forecast information for the “Fully Customizable Instrument Panel” (FCIP):
The project has an anticipated economic life of 5 years.
The company will have to purchase a new machine to produce the new product. The machine has an up-front cost (t = 0) of $2,107,000.
The equipment will be depreciated using the MACRS method using the ½ year convention with a 5 year class life:
t = 1 20.00%
t = 2 32.00
t = 3 19.20
t = 4 11.52
t = 5 11.52
t = 6 5.76
At the end of the project, the expected value (salvage value) of the equipment is $925,000.
If the company goes ahead with the proposed product, it will have an effect on the company’s net operating working capital. At the outset, t = 0, inventory will increase by $136,000 , accounts payable will increase by $52,000, and accounts receivable will increase by $41,500. At t = 5, the net operating working capital will be recovered after the project is completed.
The new product is expected to generate incremental sales revenue as follows:
Year 1: $1,200,000
Year 2: 2,500,000
Year 3: 3.250,000
Year 4: 3,100,000
Year 5: 1.575,000
The operating costs, excluding depreciation, are expected to be 59% of the annual sales.
The new product is expected to reduce the after-tax cash flows of the company’s other existing products by $175,000 a year (t = 1, 2, 3, 4, and 5).
Continued on next page:
The company’s tax rate is 40 percent.
Jamnic considers this to be a higher risk project.
The before tax cost of debt (rd) for Jamnic s 5.12%, and the common stock beta is 1.43. The current capital structure (market value) is as follows:
Jamnic Digital Automotive.
Debt $2,450,000
Equity 7,350,000
$9,800,000
Jamnic Digital Automotive uses the firm’s WACC for average risk projects, it adds 2% for high risk projects. For low risk projects it uses the WACC less 2%.
Your analysts also compiled current market information:
Market risk premium (RPm): 4%
Risk-free rate (rRF): 2.25%
Given the above information: (Show your work and calculations)
1. a. (5 points) What is Jamnic Digital Automotive’ cost of equity (rs)?2. Read all parts (a, b, c, d) first. (Show your calculations)
a. (5 points) What is the initial net cash flow (t=0) for the project?
b. (8 points) What are the operating cash flows for time periods 1 through 6?
c. (5 points) What is the total terminal cash flow for the project, recognizing the sale of the equipment and the liquidation of NOWC? (NOT the operating cash flows you found in 2.b.)
d. (5 points) On the timeline table below, show the total cash flow amount for each period based on the work you did above in a, b, c, and d.
Period
0
1
2
3
4
5
6
Cash Flow
3. Use the information below for this question: (Show your calculations)
Period Cash flow
I. Initial 0 (1,995,000)
II. Operating 1 623,500
2 739,750
3 846,000
III. Terminal 3 298,500
a. (10 points) Using these cash flows and a hurdle rate of 9.25%, what is the NPV of the project?
b. (6 points) Using these cash flows, what is the internal rate of return (IRR) for the project (to the nearest basis point)?
c. (3 points) (Choose the correct response and fill in the blank.)
If the NPV is positive, the IRR will be _______________ [greater than / less than] the hurdle rate.
The Modified IRR will be _____________ [greater than/ less than] the hurdle rate.
The Modified IRR will be _________________ [greater than/ equal to / less than] the regular IRR.
d. (5 points) Given your results in 3a. and 3b, should the project be accepted? Why?
4. (5 points)
What is the WACC for Jamnic (from 1b)? _____________
Now, is this (the WACC) the appropriate Hurdle Rate for all projects for this firm, and why (discuss)?
5. (5 points)
Beatrice, a financial analyst at Jamnic, has worked ½ time during the last year developing the project idea and proposal. She did not include her time in the project analysis you completed, however her supervisor believes that including the cost of Beatrice’s time in the cash flow estimates as an expense is appropriate. This amounts to $28,750 (one-half year salary + benefits). They have asked you how should this be handled (discuss)?
After discussions with an investment banker about issuing additional debt, your analyst found that the cost of debt (before tax) depends on the amount of debt in the capital structure. Jamnic Digital Automotive’ cost of debt estimates for various levels of debt financing (D/E) were obtained.
Fanning Analytics, Inc.
D/E
Debt/
Capital
(Wd)
rd
Equity
Beta
Equity/
Capital
(We)
rs
WACC
0.00
0.0
n.a.
1.0
0.333
0.25
5.12%
1.43
0.40
7.25%
0.60
8.00%
* Debt/Capital = Debt/(Debt + Equity),
Equity/Capital = Equity/(Debt + Equity).
6. a. (10 points) Complete the table above (show your calculations).
b. (5 points) (Choose the correct response and fill in the blank. )
If our goal is to maximize the value of the firm, the "Optimal Capital Structure" is the choice of debt and equity (D/E) that ________ [maximizes/minimizes] the firm's cost of capital (WACC).
c. (5 points) Based on the information given in the table you completed, should Jamnic Digital Automotive change its capital structure from its current level (D/E = .333)? That is, what is the firm's optimal capital structure?
7. (5 points)
Describe the approach to evaluate a bond refunding decision.
Period
0
1
2
3
4
5
6
Cash Flow
Explanation / Answer
1. Jamnic's Cost of Equity :
According to CAPM: Cost of Equity = rf + Beta (rm - rf)
rf = Risk Free Rate = 2.25%, (rm-rf) = Market risk premium = 4%, Beta = 1.43
Cost of Equity = 2.25 + 1.43 (4) = 7.97% + 2% for Higher risk project = 9.97%
a. Initial Net Cash flow = Cash Outflow for Machine + Increase in working capital
Increase in Working Capital = Increase in inventory + increase in account receivable - increase in accounts payable
Increase in Working Capital = 136,000 + 41,500 - 52,000 = $125,500
Initial Net Cash Flow = 2,107,000 + 125,500 = $2,232,500
b. Operating Cash Flow each Year:
Depreciable value = 2,107,000 - 925,000 = $1,182,000
c. Total Terminal cash flow:
Operating flow + Salvage value + Working Capital
266,916 + 925,000 + 125,500 = $1,317,416
d. Total Cash flow amount:
Year 1 2 3 4 5 Sales Revenue 1,200,000 2,500,000 3,250,000 3,100,000 1,575,000 Less: Operating Expenses 708,000 1,475,000 1,917,500 1,829,000 929,250 Less: Depreciation 236,400 378,240 226,944 136,166 136,166 Income before tax 255,600 646,760 1,105,556 1,134,834 509,584 Less: Tax(40%) 102,240 258,704 442,222 453,934 203,834 Income after Tax 153,360 388,056 663,334 680,900 305,750 Add: Depreciation 236,400 378,240 226,944 136,166 136,166 Cash Inflow 389,760 766,296 890,278 817,066 441,916 Less: Reduction in cash flow of other product 175,000 175,000 175,000 175,000 175,000 Net Cash Inflow 214,760 591,296 715,278 642,066 266,916Related Questions
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