1. Determine the new target weighted average cost of capital for Felicia & Fred,

Question

1. Determine the new target weighted average cost of capital for Felicia & Fred, given following assumptions:

Weights of 70% debt and 30% common equity (no preferred equity); this essentially reverses their previously calculated capital structure

A 35% tax rate

The cost of debt is now 10% due to an additional default risk premium

The beta of the company is 1.3

The risk free rate is 2%

The return on the market is 12%.

Use the CAPM for calculation of the cost of equity.

2. Calculate the cash flows for the new crystal jewelry project given the following assumptions:

Initial investment outlay of $25 million, comprised of $20 million for machinery with $2 million for net working capital for metal inventory and $3 million for crystals

Project and equipment life is 5 years

Revenues are expected to increase $25 million annually

Gross margin percentage is 40% (not including depreciation)

Depreciation is computed at the straight-line rate for tax purposes

Selling, general, and administrative expenses are 5% of sales

Tax rate is 35%

Compute net present value and internal rate of return of the project.

Explanation / Answer

(1)

Cost of equity, ke = Risk free rate + Beta x (Market return - Risk free rate)

= 2% + 1.3 x (12% - 2%)

= 2% + 13% = 15%

So,

WACC = Cost of equity x Proportion of equity + Cost of debt x (1 - tax rate) x Proportion of debt

= 15% x 30% + 10% x (1 - 0.35) x 70%

= 4.5% + 4.55%

= 9.50%

(2)

Additional revenue = $25 million per year

Additioal net profit per year = [($25 million x 40%) - ($25 million x 5%)] x (1 - 0.35)*

= ($10 million - $1.25 million) x 0.65 = $5.69 million

* Depreciation being non-cash expense, is excluded from project cash flow analysis.

Note: In year 5, net working capital of $5 million is added back to annual net benefit.

NOTE: Only IRR could be computed [Using Excel =IRR() function], NPV cannot be computed in absence of any discount rate mentioned.

Year Initial Investment($ million) Net Working Capital($ million) Annual Net Income($ million) Net Annual Cash Flow ($ million) (1) (2) (3) (3) - (1) - (2) 0 -20 -5 -25 1 5.69 5.69 2 5.69 5.69 3 5.69 5.69 4 5.69 5.69 5 10.69 10.69 IRR = 9.53%

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