Reference no: EM132981960

Question - DEF Company owns several businesses. The trade wars have caused a general slowdown in business and DEF has decided to downsize. DEF intends to sell its nursery and garden business for $700,000 and has approached XYZ Company as a potential buyer. XYZ is hesitant about purchasing the business as it is not confident about making the business succeed. To sweeten the deal DEF agrees to buy back the business for $400,000 in 3 years' time if XYZ wants to give up the business then.

The details relating to the project are as follows:

Cost of nursery and garden business is $700,000

No additional working capital is needed

Staff costs are $200,000 per year

Rental of land is $120,000 per year

Projected sales each year is $500,000

Variable costs (plants, gardening tools, etc.) are 10% of sales

DEF offers buy back the business for $400,000 after 3 years if XYZ does not want to continue with the business

XYZ intends to fund part of its purchase of the business using borrowing. It also intends to maintain a capital structure similar to the typical nursery and gardening firm in the industry. Financial information of a typical nursery and gardening firm are:

Typical beta = 1.5 times of market beta

Risk-free rate = 3%

Market risk premium = 6%

Corporate tax rate = 20%

Typical debt to equity ratio = 0.5

Typical WACC = 10%

Required -

1) Calculate ABC's cost of equity and cost of debt.

2) Calculate the operating cash flows related to the project.

3) Calculate the NPV of the project assuming XYZ intends to run the business for three years only. Use a discount rate of 10%.

4) Suppose XYZ intends to run the business forever, solve for the IRR associated with the project.

5) Interpret your results from parts (c) and (d) and discuss whether XYZ should buy the nursery and gardening business.