Felicia & Fred’s executive board have asked you to complete a decision model for
ID: 2779240 • Letter: F
Question
Felicia & Fred’s executive board have asked you to complete a decision model for their intended refurbishment of the former mill building. In order to make an appropriate decision, the executive team has provided you with the following information regarding WACC and cash flows. It is your job to calculate the decision rules for NPV and IRR given the information provided.
Requirements:
1. Determine the target weighted average cost of capital for Felicia & Fred, given following assumptions:
Weights of 30% debt and 70% common equity (no preferred equity)
A 35% tax rate
The cost of debt is 9%
The beta of the company is 1.2
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 of the project given the following assumptions:
Initial investment outlay of $60 million, comprised of $50 million for machinery with $10 million for net working capital (metal and gemstone inventory)
Project and equipment life is five years
Revenues are expected to increase $50 million annually
Gross margin percentage is 60% (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 30%, a reduced rate that reflects a tax credit due to the repurpose of the building
Explanation / Answer
1) Using the CAPM model,
Cost of Equity = Risk free rate + Beta * (Market Risk Premium) = 2% + 1.2 * (12% - 2%)
= 2% + 1.2 * 10% = 2% + 12% = 14%
2) WACC = Cost of Debt * Weight of Debt * (1 - Tax Rate) + Cost of Equity * Weight of Equity
= 0.3 * 9% * (1 - 30%) + 0.7 * 14%
= 11.69%
Initial Investment = $60million
For years 1 to 5
Incremental Revenue = $50 million
COGS = 40% of Revenue = 0.4 * 50 = $20million
Gross Profit = 50 -20 = $30 million
Annual Depreciation = 50/5 = $10 million
SG&A Expenses = 5% * 50 = $2.5million
EBIT = 30 - 10 - 2.5 = $17.5million
Operating Cash Flow = EBIT * (1 - Tax Rate) + Depreciation = sh flow 17.5 * ( 1 - 30% ) + 10 = $22.25million
Terminal cash flow in year 5 = Recovery of net working capital = $10million
Total cash flow in year 5 = 22.25 + 10 = $32.25million
The cash flows look like this:
NPV is the sum of discounted cash flows = $26.58 million
IRR can be found out using the IRR function of excel. It is coming out to be 27.39%.
Year Cash Flow( in $million) Discounted Cash Flow( in $million) 0 -60 -60.00 1 22.25 19.92 2 22.25 17.84 3 22.25 15.97 4 22.25 14.30 5 32.25 18.55 NPV 26.58 IRR 27.39%Related Questions
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