| 2.1 As the director of a firm's capital budgeting department, you have been asked to evaluate a project. After collecting information from various sources, you have determined the following: The firm's preference share pays a constant annual dividend of R2.25 and is currently selling for R20. The firm is expected to pay an ordinary share dividend of R3 in one year, with anticipated growth of 2% each year thereafter. Currently, the ordinary share is selling at a price of R23.75. The firm has 8-year bonds outstanding with a coupon rate of 8.75%, paid annually. The bonds are currently selling at par. The firm is currently being financed with R10 000 000 debt, R20 000 000 of ordinary equity, and R5 000 000 preference shares. The project requires the use of equipment valued at R6 200 000.This is the replacement project |
| The equipment currently has a book value of R3 000 000 with two years of straight-line depreciation (to zero) remaining (R1 500 000 each year). You anticipate that the equipment can be sold in three years for R2 100 000. Anticipated sales are 1 000 000 units per year based on a sale price of R11 per unit. The cost of producing each unit is R8.50. If the project is accepted, the firm will need to hire an additional manager with an annual salary of R80 000. Total research (information gathering for project analysis) expenses to date are R26 000. The firm's marginal tax rate is 40%. |
| 2.1.1 Calculate the net present value of this project and the internal rate of return. Should the project be accepted? (25) |
| 2.2 In the context of capital budgeting, what is an opportunity cost? Provide an example of an opportunity cost. (2) |
| 2.3 ‘Since depreciation is a non-cash expense, we should ignore its effects when evaluating projects.’ Is this statement true? Please elaborate. (3) |
| First we calculate Cost of capital (WACC) |
| Cost of preferred Share = kps= $2.25/$20 = | 11.25% |
| Cost of Common Share = ks= D1/P0+ g = $3/$23.75 + 2% | 14.63% |
| Cost of Debt after tax kd = 8.75% x (1 - 40%) | 5.25% |
| | Weight | Cost | WACC |
| Preferred Share = wps= $5,000,000/$35,000,000 | 14.29% | 11.25% | 1.61% |
| Common share = $20,000,000/$35,000,000 | 57.14% | 14.63% | 8.36% |
| Debt = wd= $10,000,000/$35,000,000 | 28.57% | 5.25% | 1.50% |
| Total | | | 11.47% |
| $26,000 research expense is a sunk cost and therefore should not affect the analysis |
| NPV analysis |
| Year | 0 | 1 | 2 | 3 |
| Sales (1,000,000 units x $11) | | $ 11,000,000.00 | $ 11,000,000.00 | $ 11,000,000.00 |
| Less: Cost (1,000,000 units x $8.50) + $80,000 | | $ 8,580,000.00 | $ 8,580,000.00 | $ 8,580,000.00 |
| Less: Depreciation | | $ 1,500,000.00 | $ 1,500,000.00 | 0 |
| EBT | | $ 920,000.00 | $ 920,000.00 | $ 2,420,000.00 |
| less: Tax | | $ 368,000.00 | $ 368,000.00 | $ 968,000.00 |
| EAT | | $ 552,000.00 | $ 552,000.00 | $ 1,452,000.00 |
| Add: Depreciation | | $ 1,500,000.00 | $ 1,500,000.00 | $ - 0 |
| Operating Cash flow | | $ 2,052,000.00 | $ 2,052,000.00 | $ 1,452,000.00 |
| Salvage CF = $2,100,000 - (($2,100,000 -$0) x 0.4) = | | | | $ 1,260,000.00 |
| Initial Investment | $ (6,200,000.00) |
| Net Cash flow | $ (6,200,000.00) | $ 2,052,000.00 | $ 2,052,000.00 | $ 2,712,000.00 |
| PV @ 11.47% | 1 | 0.8971180924 | 0.8048208718 | 0.7220193653 |
| Present Value | $ (6,200,000.00) | $ 1,840,886.33 | $ 1,651,492.43 | $ 1,958,116.52 |
| NPV | $ (749,504.73) |
| IRR | 4.66% |
| Project should not be accepted since NPV is negative and IRR is less the cost of capital |
| b) |
| Opportunity cost is benefits of investing capital in a project that is forgone when that capital is invested in some other alternative |
| Capital Expenditure: -$6,200,000 at date 0 is an opportunity cost. | | | | | | | https://studylib.net/doc/8937258/sample-capital-budgeting-problems |
| | | | | | | | https://slideplayer.com/slide/7429885/ |
| c) |
| Depreciation is a non-cash expense, but it is tax-deductible on the income statement. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced by an amount equal to the depreciation tax shield tcD. A reduction in taxes that would otherwise be paid is the same thing as a cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental after tax cash flows. |
11aug1975
directorofafirmscapital.xlsx
