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Question - It is expected to generate annual net earnings of £1.2million indefinitely in the future. DEF plc. uses a mix of both equity and debt to fund its current activities. It has issued 3 million ordinary shares currently trading at £2.50 each and 25,000 irredeemable debentures currently trading at £105 each. Debentures have a nominal value of £100 and an annual coupon rate of 8%.
DEF plc. has decided to invest £1.3million into new investments. It has currently identified two new indivisible potential projects. The financial manager has estimated the following net cash flows associated with each of the new projects:
Net Earnings from Project A (£)
Net Cash Flows from Project B (£)
Initial Investment
(600,000)
(850,000)
Year 1
0
100,000
Year 2
250,000
Year 3
300,000
Year 4
400,000
Year 5
Both projects' have a similar risk to the systematic risk of the existing portfolio of company's operations. Both projects are expected to have a zero-residual value at the end of their lives. DEF plc uses a straight-line method to depreciate its assets.
Required - Calculate DEF's cost of capital and estimate the Net Present Value (NPV), IRR (internal rate of return) and PP (payback period) of each project. Explain in detail, which project(s) the company should undertake. State all assumptions made.
Showing your calculations, suggest whether projects A and B are more sensitive to the discount rate or initial investment.
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