Suppose a company has hired you to estimate the cash flows arising from a proposed capital project by replacing old equipment with a $0 market value and a book value of $100,000, and you have been handed the relevant data below. The project being considered has a 5-year tax life, and at the end of year 5 the asset will be worthless (i.e. salvage value =0). The CFO suggests that you depreciate the asset by using the straight-line method over the 5 year life of the project. Revenues and other operating costs are as noted below, and will be constant over the period.
Equipment cost: $1,750,000; Book value of old equipment: $100,000
Delivery and installation cost of equipment and remove old equipment: $500,000;
Straight-line depreciation rate: 20% (5-year); Inflation: 3% per year.
Sales unit in the 1st year: 25,000 Sales price per unit $120
Cost per unit: $80 Sales growth per year: 6%
Operating costs (excluding depreciation, assume it is fix costs): $300,000; Tax rate: 34%
The project requires a working capital equal to 9% of next year’s sales.
1. What are annual free cash flows for the next five years? Hint: find CF0 to CF5 (40 points)
2. Plan A: Suppose CFO will issue corporate bonds to cover 50% of capital, the bond will issue at par, with 5-year maturity, 10% semiannual coupon, and floatation cost is 4%. The other 50% of capital through equity. The risk-free rate is 4%, the company beta is 1.6, and market portfolio has 15% return. What is the cost of capital for this project? (10 points) What is the net present value (5 points) of this project and What is the IRR (5 points) and MIRR (10 points) for this project? Should you convince the CFO to accept or reject the new equipment, and briefly explain why? (5 points)
3. Plan B: Suppose CFO will borrow 35% of capital through local bank with 9% interest rate. The other 65% of capital throughissue new stocks. The current stock price is $17 per share, and assume the newly issue stock has the same price, the last dividend is $2.36, and the floatation cost is 15%. The stock has a constant growth rate equal to the project. What is the cost of capital for this project? (10 points) What is the net present value (5 points) of this project and What is the IRR (5 points) and MIRR (10 points) for this project? Should you convince the CFO to accept or reject the new equipment, and briefly explain why? (5 points)
4, please find Time Interest Earned (TIE) ratios for both plan A and plan B during the year 1 – 5, and explain which plan is more favorable to creditors. (10 Points). If creditor demands the firm to maintain TIE ratio above 3.5, what are the consequences? (5 points)
Hint: To determine the annual interest paid, use the following: INT($) = Debt x i
(where i = interest rate in %).