Calculate before-tax rate of interest on the mortgage loan

Reference no: EM132179140

Assignment -

Question 1 - Following consideration of a feasibility study which cost $50,000, Richside Industries is considering an expansion of its operations by introducing a plant extension. The new plant will cost $1,000,000 to erect and operate on some existing land owned by Richside. Richside was considering selling the land, which has an estimated market value of $500,000, but has now decided to use it for the plant extension. Additional raw materials and inventory of $500,000 will be required to support the new operation.

The feasibility study estimated the project will have a life of 10 years. Analysis of product market conditions indicated the project will generate annual revenues of $1,500,000 and factor market analysis indicated annual operating expenses of $950,000. A Head Office expense loading of $150,000 per annum has been allocated to the project in addition to increased operational overheads of $100,000 per annum. Interest expense will increase by $75,000 per annum.

The plant will be depreciated straight line over the life of the project. Tax is paid in the year of income.

The weighted average required rate of return appropriate to the project is 15% and the corporate tax rate is 40%.

Required: Advise whether Richside Industries should go ahead with the project.

Question 2 - Poorside Industries recently commissioned management consultants to estimate an appropriate cut-off rate for investment projects with the same risk as the firm. Unfortunately, part of the report was lost, and you have been asked to calculate the missing figures. Fortunately, the following information was available from the report:

1. The consultants estimated the required rate of return (wacc) was 13.635%

2. The Beta of Poorside's equity was 0.7, the market return was 20% and the risk-free rate was 12%

3. The interest rate on debentures was 13% per annum

4. Debt items were recorded at market values

a. Mortgage loan: $1,500,000

b. Debentures: $2,500,000

5. Share capital had a market value of $6,000,000

6. The consultants believed the capital structure was optimal

7. The corporate tax rate was 40%

Required: Calculate the before-tax rate of interest on the mortgage loan required to arrive at the consultants' estimate of the required rate of return.

Reference no: EM132179140

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