3 October 2003 FIN2101 BUSINESS FINANCE II MOdULE 9-INTERACTION OF INVESTMENT AND FINANCING DECISIONS QUESTION Briggs Boxing and Packaging Ltd is considering expanding its operations. The expansion project will cost $1 400 000 and will have a 6-year life. It is produce annual before-tax cash inflows of $1 500 000. Before-tax fixed costs estimated to be $400 000 per annum, while before-tax variable costs will be 35% of the estimated cash inflows The firm has a tax rate of 30%, an unlevered opportunity cost of capital of 18%,a cost of debt of 12% and a debt -to-value ratio of 0.25 Should the company undertake the expansion project? QUESTION 2 Termite Ltd is evaluating an expansion project that requires an investment in equipment costing $9 million, with an expected useful life of 5 years. The equipment will be depreciated using the straightline method to zero over its 5-year life. However, it is expected that the equipment will be sold at the end of the 5 years for $1 million The project will increase before-tax net cash inflows by $2.5 million per annum in years 1 and 2, by $4 million per year in years 3 and 4, and by $2 million in year 5 The project is to be partly financed by way of a debt issue to raise $3 million at a cost of 10%. The balance will come from an equity issue, which will incur issue costs of 2% of the gross pro The tax rate is 30% and the cost of equity for an equivalent all-equity financed company is 16% Using the APV approach, should the company proceed with the expansion project? assume that the tax shield on has the same risk as the interest payments themselves
3 October 2003 FIN2101 BUSINESS FINANCE II MODULE 9 – INTERACTION OF INVESTMENT AND FINANCING DECISIONS QUESTION 1 Briggs Boxing and Packaging Ltd is considering expanding its operations. The expansion project will cost $1 400 000 and will have a 6-year life. It is expected to produce annual before-tax cash inflows of $1 500 000. Before-tax fixed costs are estimated to be $400 000 per annum, while before-tax variable costs will be 35% of the estimated cash inflows. The firm has a tax rate of 30%, an unlevered opportunity cost of capital of 18%, a cost of debt of 12% and a debt-to-value ratio of 0.25. Should the company undertake the expansion project? QUESTION 2 Termite Ltd is evaluating an expansion project that requires an investment in equipment costing $9 million, with an expected useful life of 5 years. The equipment will be depreciated using the straightline method to zero over its 5-year life. However, it is expected that the equipment will be sold at the end of the 5 years for $1 million. The project will increase before-tax net cash inflows by $2.5 million per annum in years 1 and 2, by $4 million per year in years 3 and 4, and by $2 million in year 5. The project is to be partly financed by way of a debt issue to raise $3 million at a cost of 10%. The balance will come from an equity issue, which will incur issue costs of 2% of the gross proceeds. The tax rate is 30% and the cost of equity for an equivalent all-equity financed company is 16%. Using the APV approach, should the company proceed with the expansion project? Assume that the tax shield on debt has the same risk as the interest payments themselves
3 October 2003 QUESTION 3 Tipsy Ltd is considering build ing a new hotel that will cost $5 million to establish. It is estimated that the new hotel will generate before-tax annual sales of $2 million The costs of goods sold will be 40% of sales revenue and the company will incur annual marketing and administrative costs of $400 000 before tax. These cash flows are in perpetuity The cost of debt is 11%, the opportunity cost of capital for an all-equity financed firm is 14%, and the firms cost of equity(ks)is 16%. Tipsy has a tax rate of 30% and a target debt-to-value ratio of 0.35 Using the flow-to-equity method, calculate the net present value of the proposed new
3 October 2003 QUESTION 3 Tipsy Ltd is considering building a new hotel that will cost $5 million to establish. It is estimated that the new hotel will generate before-tax annual sales of $2 million. The costs of goods sold will be 40% of sales revenue and the company will incur annual marketing and administrative costs of $400 000 before tax. These cash flows are in perpetuity. The cost of debt is 11%, the opportunity cost of capital for an all-equity financed firm is 14%, and the firm’s cost of equity (ks) is 16%. Tipsy has a tax rate of 30% and a target debt-to-value ratio of 0.35. Using the flow-to-equity method, calculate the net present value of the proposed new hotel
3 October 2003 FIN2101 BUSINESS FINANCE II SOLUTIONSTO TUTORIAL QUESTIONS MODULE 9-INTERACTION OF INVESTMENT AND FINANCING DECISIONS
3 October 2003 FIN2101 BUSINESS FINANCE II SOLUTIONS TO TUTORIAL QUESTIONS MODULE 9 – INTERACTION OF INVESTMENT AND FINANCING DECISIONS
3 October 2003 QUESTION I Step 1- Calculate the Unlevered Cash Flow (UCF) Cash inflows $l500000 Less fixed c 400000 ess Variable costs (35%) Operating income 575000 Less Tax(30%) UCF $402500 Step 2- Calculate ks k,=ko+(1-T)(k0-kd) 0.18+ 0.30)(0.18-0.12 =0.18+0.014 =0.194or194% Step 3-Calculate the wacc D k =k 1-T)× 25 0.194 +0.12×(1-0.30)× =0.1455+0021 0.1665or1665%
3 October 2003 QUESTION 1 Step 1 – Calculate the Unlevered Cash Flow (UCF) Cash inflows $1 500 000 Less Fixed costs 400 000 Less Variable costs (35%) 525 000 Operating income 575 000 Less Tax (30%) 172 500 UCF $ 402 500 Step 2 – Calculate ks ( )( ) ( )( ) 0.194 or 19.4% 0.18 0.014 1- 0.30 0.18 - 0.12 3 1 0.18 1- T k - k E D ks k0 0 d = = + = + = + Step 3 – Calculate the WACC ( ) ( ) 0.1665 or 16.65% 0.1455 0.021 100 25 0.12 1- 0.30 100 75 0.194 V D k 1- T V S ka ks d = = + + = = +
3 October 2003 QUESTION 1(Continued) Step 4-Calculate NPV NPV=$402500× PVIFA $l400000 (s402500×3622)-$140000 $1457855-$1400000 $57855 The project has a positive NPV and should be accepted
3 October 2003 QUESTION 1 (Continued) Step 4 – Calculate NPV ( ) $57 855 $1457 855 - $1400 000 $402 500 3.622 - $1400 000 NPV $402 500 PVIFA0.1665,6 - $1400 000 = = = = The project has a positive NPV and should be accepted