question archive In the wake of the significant oil spill at PetroJam Limited which amounted to over 600,000 barrels of oil, the board of directors is considering the purchase of new equipment that will save oil over a four year period
In the wake of the significant oil spill at PetroJam Limited which amounted to over 600,000 barrels of oil, the board of directors is considering the purchase of new equipment that will save oil over a four year period
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In the wake of the significant oil spill at PetroJam Limited which amounted to over 600,000 barrels of oil, the board of directors is considering the purchase of new equipment that will save oil over a four year period. The equipment is expected to save 600,000 barrels over the relevant planning period above. Currently each barrel of oil can be sold for $1,000. It is also expected that the equipment will be fully utilized over the four year period and have no value at the end of the period. The equipment is to be depreciated using the straight line basis in accordance with Petro Jain's accounting policy.
The equipment is expected to cost $250 million and will incur shipping, installation and testing cost of $10 million, $40 million and $60 million respectively. PetroJam is expected to issue 9 million new ordinary shares to assist with the financing of the new equipment. The current price of the new shares is expected to be $10 each. Each share is expected to pay dividend of $2 and dividends are expected to grow by 5% into the foreseeable future. The remainder of the project will be financed by bonds amounting to $270 million dollars. The bonds are to be traded on the Jamaican Stock Exchange (ISE). The bonds are expected to have a coupon rate of 10%, and a yield to maturity representing 12%.
The corporate tax rate in Jamaica is 25% and all cash flows occur at the end of each period. The board of directors wants to ascertain the financial feasibility of the new equipment given that the entity is also planning to employ the services of four engineers who will work exclusively for the new project. Each engineer is expected to receive gross annual salary of $25 million, but the entity will contribute an additional 12% of the gross salaries for payroll taxes.
Required:
a. Define the term, cost of capital.
b. Compute the cost of capital
c. Distinguish between hard and soft capital rationing.
d. Evaluate the financial feasibility of the project based on net present value
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Answer:
a). Cost of capital is the minimum return that the company should earn on a project before recovering the investment channeled into the project. The total investment otherwise referred to as initial capital outlay is the cost of capital for an investment decision.
b). Cost of capital: equity + preferred stock
Common stock: 9 million * $10 $90 Million
Dividends $2( 1.05)^4. *9M $2 1.6Million
Bonds. $270 Million
Interest 4(10% *$270M). $108 Million
Total cost. $489.6Million
c). Hard capital rationing is the ability of the company to raise capital from external sources by issuing debt instruments such as bonds as noted in this question while soft capital rationing is the ability to source funds internally through the issue of the common stock. In this question, soft capital rationing has been noted with the issue of 9 million common shares.
d) Revenue 600,000 barrels * $1,000 = $600,000,000 *4
= $2,400,000,000
Use the 10% discount rate
PV = FV/(1+r)^t
$2,400,000,000/(1.1)^4
=1,629,232,293
Less
Purchase. ($250,000,000)
Testing. ( $40,000,000)
Installation. ($60,000,000.)
Salaries. ($100,0000,000)
Capital cost ($489,600,0000)
Net profit. $689,232,293
Less tax 25% ($172,408,073)
Profit. $517,224,219.75
The project is feasible. It should be taken as the NPV is positive.
