Suppose you are evaluating a project for The Ultimate Golf Club, guaranteed to c
ID: 2804006 • Letter: S
Question
Suppose you are evaluating a project for The Ultimate Golf Club, guaranteed to correct the hacker's slice. You estimate the sales price of The Ultimate to be $400 and sales to be 1,000 units per year. You figure the project has a life of 3 years. Variable costs amount to $200 per unit and fixed costs are $120,000 per year. The project requires an initial investment of $165,000 which is depreciated straight-line over 5 years. The actual market value of the initial investment after year 3 is $45,000. Net working capital investment is $75,000. The tax rate is 34%.
The risk of this project is very similar to the company's other businesses. The company's capital structure is as follows:
Common Stock: 1 million shares outstanding, currently selling for $35 per share. The stock has a Beta of 1.2.
Bonds: 20,000 bonds outstanding, $1000 face value for each bond, 7% annual coupon, 10 years to maturity, Selling at 100% of par.
Market risk premium: 8%
Risk free rate: 6%
a. What is the project's operating cash flow during its three-year life? (8 points)
b. What is the project's total cash flows? (8 points)
c. What is the firm's WACC? (8 points)
d. What is the project's NPV? (8 points)
e. What are the minimum operating cash flows needed for the NPV to be zero? (8 points)
Explanation / Answer
The initial investment is 165000
Net working capital is 75000
Thus initial outlay of the project = FCinv + WCinv
=165000+75000
=240000
The project is to be depreciated over the 5 years life using SLM thus deprecitaion = 165000 / 5 = 33000
After three years the projects book value = 165000-(3*33000) = 66000
and the salvage value given of the project at the end of year three = 45000
tax rate = 34%
Terminal year cashflow = salvage+WCinv - tax*(salvage-bookvalue)
=45000+75000 - 0.34*(45000-66000)
=120000 - (-7140)
=127140
Answer a.
sales = 400*1000 = 400000
variable cost = 200*1000 = 200000
Fixed cost = 120000
After tax opertaing cashflow = (sales-variablecost-fixedcost-depreciation)*(1-tax) + Depreciation
=400000-200000-120000-33000*(1-0.34) + 33000
=64020
answer b.
total cashflow for the project is:
Year
cashflow
0
-240000
1
64020
2
64020
3
191160
Total cashflow
79200
Answer c.
The firms WACC = We*ke + Wd*Kd
Ke = rf + beta*(rm-rf) = 6+1.2*(8) = 15.6%
Kd = coupon*(1-tax) = 7*(1-0.34) = 4.62%
Total equity = 1 million shares * 35 per share = 35 million = 35,000,000
Total debt = 20000 outstanding bonds * 1000 par value = 20,000,000
Total capital = 55,000,000
Wd = 20,000,000 / 55,00,000 = 0.3636
We = 35,000,000 / 55,00,000 = 0.6364
WACC = We*Ke + Wd*Kd
=0.6364*15.6 + 0.3636*4.62
=9.9278 + 1.6798
=11.6076%
Answer d.
NPV of the project at WACC of 11.6076% is
Year
cashflow
0
-240000
1
64020
2
64020
3
191160
NPV at WACC of 11.6076%
$5,610.43
Answer d.
To have NPV of Zero the cashflows should be equal to 61435
Year
cashflow
0
-240000
1
64020
2
64020
3
191160
Total cashflow
79200
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