WACC and Capital Budgeting Problem: Apple Inc. is trying to solve an issue with
ID: 2755355 • Letter: W
Question
WACC and Capital Budgeting Problem: Apple Inc. is trying to solve an issue with short supply and poor distribution of its latest iPhone model in the Midwest. The company is considering a new manufacturing and distribution center near the new RidgePort Intermodal facility in Wilmington, IL. The project would include acquiring land at a price of $2 million, constructing a 500,000 sf industrial building at a cost of $14 million, and the purchase of equipment for approximately $1 million. This is believed to be a relatively short-term capital project that will last only four years, as analysts expect technological advancements to speed up the automation process during this time. At the end of the project, analysts believe the land and building will sell for $15 million. The equipment will have no salvage value because it will be outdated. As a respected employee in the Company’s corporate finance department, you have been assigned to assess the project’s feasibility. Recently asking for a raise, you’ve decided to evaluate all facets of the project, from determining Apple Inc.’s WACC, to making a recommendation based on your projection of free cash flow. (Please use the timeline provided on a separate page. You are required to turn in the timeline). WACC:
a. Apple Inc.’s noncallable bonds currently sell for $1,486. They have a 10-year maturity, an annual coupon rate of 10%, and a par value of $1,000. Assuming Apple’s corporate tax rate is 40%, what is the cost of debt?
b. Apple Inc.’s preferred stock sells for $300 and it pays an annual dividend of $15. What is the company’s cost of preferred stock?
c. Apple Inc.’s common stock currently sells for $118 per share and just paid a dividend of $3.37. The future earnings, dividends, and common stock are expected to grow 5% per year. Using the DCF approach, what is the common cost of equity?
d. Using your answers from questions a. through c., and assuming Apple Inc.’s targeted capital structure consists of 55% debt, 5% preferred stock, and 40% common equity, what is the company’s WACC?
Capital Budgeting: Please use the timeline provided on a separate page. You are required to turn in the timeline.
e. The company expects inventory to increase by $2 million, and accounts payable to increase by $1 million. Including the land, construction, and equipment purchases, what is the initial investment outlay?
f. The company believes that cash flow during the life of the project will be the same each of the four years, summarized as follows: Sales revenue: $75,000,000 Operating Costs (excluding depreciation): 67,500,000 Depreciation: 950,000 Interest Expense: 680,000 Tax Rate: 40% What is the project’s annual cash flow?
g. At the end of the project, the building and land will have a book value of $11.2 million. The equipment will have a book value of $0. All inventories will be converted to finished product and sold. What is the terminal cash flow in year 4? (Remember, terminal cash flow would also include the change in net operating working capital).
h. Compute the project’s NPV. Using NPV as a determinant, why should this project be accepted or rejected?
i. Compute the project’s IRR. Using IRR as a determinant, why should this project be accepted or rejected?
j. Compute the project’s MIRR. Using MIRR as a determinant, why should this project be accepted or rejected?
Explanation / Answer
a. Cost of debt = i (1-t)
= 10( 1-40%)
= 6% p.a.
b. cost of preferred stock = dividend/ value of preferred stock *100
= 15/300*100
= 5 % p.a.
c. cost of common equity
As per DCF, Po= D1/ Re- G
118= (3.37*1.05) / Re- 0.05
Therefore Re = 8 % p.a.
d. WACC= 6*55%+ 5*5%+ 8*40%
= 6.75% p.a.
e, Initial investments = Cost of land + construction of building + Purchase of equipment + working capital requirement
= $ 2 +14 +1 +(2-1)
= $ 18 Millions
f. Calculation of projected annual cash flows
Amount in $
Sales revenue 75000000
(-) cost of operations 67500000
(-) depreciation 950000
(-) Interest expenses 680000
Profit before tax 5870000
(-) Tax @ 40% 2348000
Profit After tax 3522000
(+) Depreciation 950000
Projected cash flow after tax 4472000
g. Calculation of terminal cash flow in year 4
i. post tax salvage value of land and building= $ 15- ($15-11.2)*40% = $ 13.48 million
ii. Net operating working capital = $ 2 million
iii. Terminal cash flows (i +ii ) = $ 15.48 million
h. NPV= PV of Expected cash flows- Initial investments
PV of Expected cash flows= 4472000* PVIFA (6.75%,4) + 15480000* PVIF (6.75%,4)
= $ 15233493 + 11920636
= $ 2,71,54,129
(-) Initial Investments = $ 1,80,00,000
NPV = $ 91,54,129
Since NPV is positive the project should be accepted.
i. IRR is given by -
outflow= inflow
$ 1,80,00,000 =4472000* PVIFA (r,4) + 15480000* PVIF (r,4)
let r = 10%
R.H.S = 14175638 + 10573048 = $ 24748686
let r = 20%
R.H.S = 11576821 + 7465278 = $ 19042099
let r = 25%
R.H.S = 10561075 + 6340608 = $ 16901683
By interpolation method, IRR = (r-20) / (25-20) = 0.4869
Therefore IRR = 22.43 %
The project should be accepted as the IRR > ROR
j. MIRR = Sqaure root of n times [(Sum of Terminal Cash Flows / Initial Investment)] - 1
= (15.48 / 18 ) ^1/4- 1
= -3.7 %
The project should not be accepted as the MIRR is negative.
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