Reference no: EM133264714

Cost of Capital

A company is considering a 5-year project to produce and sell machines. The project will use land that was purchased for $9.0 million three years ago for a different project that did not proceed. The land has recently been appraised to have a value of $9.5 million. It is anticipated that in 5-years the land will have an after-tax value of $9.7 million, although the company does not anticipate selling the land in 5 years but instead using it for other projects. The project requires building a new manufacturing plant on this land. The plant and new equipment will cost $45 million.

The following market data on the company's securities is as follows:
Debt: 300,000 5.6 percent coupon bonds outstanding, 30 years to maturity, selling for 98 percent of par, the bonds have a $1,000 par value each and make semi-annual payments. Common stock: 7,500,000 shares outstanding, selling for $58 per share; the beta is 1.40. Preferred stock: 1,450,000 shares of 6.25 percent preferred stock outstanding, selling for $92 per share and having a par value of $100.

Market: 6.5 percent expected market risk premium; 2.8 percent risk-free rate.
The company has flotation costs of 7.0 percent on new common stock issues; 5.0 percent on new preferred stock issues, and 3.5 percent on new debt issues. The company's tax rate is 30 percent.

The project requires $1,800,000 in initial net working capital investment to get operational. Assume the company raises all equity for new projects externally.

Question 1. Calculate the projects initial time 0 cash flow, taking into account all side effects. [Assume that the initial working capital does not require the company to raise outside funds.]

Question 2. The new project is somewhat riskier than a typical project for the company. You believe that an adjustment factor of +2 percent is required to account for the increased riskiness. Calculate the appropriate discount rate to use when evaluating the project.

Question 3. The plant has an eight-year tax life and the company uses straight-line depreciation. At the end of the project (i.e., the end of year 5), the plant and equipment can be scrapped for $8.5 million. What is the after-tax salvage value of this plant and equipment?

Question 4. The company will incur $8,900,000 in annual fixed costs. The plan is to manufacture and sell 26,000 machines per year at $8,600 each; the variable cost of production are $7,600 per machine. What is the annual operating cash flow from this project?

Question 5. What is the project's NPV? [Note that the net working capital should be added back at the end of year 5.]