You are considering a capital budgeting proposal glow-in-in-the-dark pacifiers f
ID: 2750219 • Letter: Y
Question
You are considering a capital budgeting proposal glow-in-in-the-dark pacifiers for anxious first time parents, You estimate that the equipment to make the pacifiers would cost you $50,000 (which you can depreciate as a 5-year property (MACKS) for tax purposes) and that you can sell 15,000 units a year at $2 a unit. The cost of making each pacifier would be $0,80. and the tax rate you would face would he 40% You also estimate that you will need to maintain an inventory at 25% of annual revenues for the period of the project and that you can salvage 80% of this working capital al the termination of the project. Also assume that the initial working capital investment will occur at the initiation of the project. Finally, you will be setting up the equipment in your garage, which means you will have to pay $2,000 a year to have your car garaged at a nearby private facility. (Assume that you can deduct this cost for tax purposes). To estimate the discount rate for this project, you find that comparable fims are being traded on the financial markets with the following betas: Company Debt-Equity Ratio Tai Kale Beta Nuk - Nuk 0.50 0 40 1.3 Gerber 1.00 0.50 1.5 You expected to finance this project entirely with equity, the current Treasury Bond rate is 11. 5% and the return on the most commonly used market index is 6% What is the appropriate discount rate to use for this project Should the project be accepted Explain your decision.Explanation / Answer
a)
Appropriate discount rate:
Ki = Krf + (Km – Krf) B
Where,
Ki = Appropriate discounts rate
Krf = Risk free interest rate
Km = Interest rate at market
B = Beta
Company Nuk:
Ki = Krf + (Km – Krf) B
= 0.115 + (0.06 – 0.115)1.3
= 0.115 + (-0.055)1.3
= 0.115 + 0.0715
= 0.1865 or 18.65 or 19%
Company Gerber:
Ki = Krf + (Km – Krf) B
= 0.115 + (0.06 – 0.115)1.5
= 0.115 + (-0.055)1.5
= 0.115 + 0.0825
= 0.1975 or 19.75% or 20%
Since company Gerber has highest discount rate, hence NPV should be calculated for this project to know whether positive cash flows arise from this project.
b)
In order to know which project should be accepted, NPV should be calculated and if the NPV is positive, then project can be acceptable or else not.
NPV:
Cash flows = 15,000 units * $2 per unit
= $30,000
Less: Garage charges = $2,000
Since there is a positive NPV of $33,738, this project is acceptable.
Year Cash in flows (a) Present value factor at 20% (1/1.20=) (b) Present value of cash flows ($) ( c = a*b) 1 28,000 0.8333 23333.33333 2 28,000 0.6944 19443.2 3 28,000 0.5787 16203.6 4 28,000 0.4823 13504.4 5 28,000 0.4019 11253.2 Total present value 83737.73 Less: Investment 50,000 Positive NPV 33,738Related Questions
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