question archive The company is considering a new investment project which has the same risk as existing businesses
The company is considering a new investment project which has the same risk as existing businesses
Subject:FinancePrice:2.87 Bought7
The company is considering a new investment project which has the same risk as existing businesses. The initial outlay for the new project is $50 million. The company expects that the project will generate additional earning of $9 million per year. The company currently has no debt. The current annual earnings available to common stockholders are $60 million.
The company currently has 4 million shares outstanding. Currently, the required rate of return on equity is 12%. Tranditionally, the company has paid out all earnings to shareholders as divideds and financed capital expenditures with new issues of common stock. All earning streams are assumed to be perpetuites. There are no taxes and no bankruptcy costs.
1. Analyze the value of the firm if common stock is issued to finance the project.
2. One of the banks suggest the company issue $45million, 8% perpetual bonds to finance the project. Advise the value of the company and the rate of return required by stockholders.
3. The financial manager has been asked to perform a lease-versus-pruchase analysis on a new machine. The machine costs $180,000 and will be depreciated by straight line method with no residual value over 5 years. Alternatively, the company can lease the machine with year-end payment of $47,500 over 5 years. Assume that the company's tax rate is 35% and its before-tax costs of borrowing is 10%. Should the company lease or purchase the machine? Support your answer with calculations.
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Answer:
1) Here cost of capital is 12%
Net present value of investment project = PV of cash inflow less cash out flow
=(9 million /12%) - 50 million
=75 million -50 million
=25 million
Thusvalue of firm = (60/12% )+25
=500+25 = 525 million
2) Statement showing WACC
| Source of capital | Amount | Weight | K | WACC= Weight*K |
| Debt | 45 | 90% | 8% | 7.20% |
| Equity | 5 | 10% | 12% | 1.20% |
| 50 | 8.40% |
Value of firm = (60 million/12%) + (9/8.4% -50)
=500+(107.1429 - 50)
=500+57.14286
=$ 557.14286 million
3) Option 1) lease
After tax cost of borrowing = 10%(1-0.35) = 6.5%
PV of lease = (Lease payment)(1-tax reate) * PVIFA(6.5%,5 years)
=47500(1-0.35)*4.156
=30875*4.156
=128316.5$
Option 2) Buy
Depreciation = 180000/5 = 36000
Tax savings each year = 36000 *35% = 12600
PV of tax savings = 12600*PVIFA(6.5%,5 years)
=12600*4.156
=52365.6
NPV = 180000-52365.6
=127634.4
Thus in buying option there is less cash outflow, hence one should buy the machine
( Assuming cash is available for purchase. Another view is that one need to borrow money and then calculate the NPV)
