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