Question
A company is considering a 7-year project to produce and sell machines. The project will use land that was purchased for $6.0 million three years
A company is considering a 7-year project to produce and sell machines. The project will use land that was purchased for $6.0 million three years ago for a different project that did not proceed. The land has recently been appraised to have a value of $7.5 million. It is anticipated that in 7-years the land will have an after-tax value of $8.2 million, although the company does not anticipate selling the land in 7 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 $35 million. The following market data on the companys securities is as follows:
Debt: 100,000 7.8 percent coupon bonds outstanding, 20 years to maturity, selling for 97 percent of par, the bonds have a $1,000 par value each and make semi-annual payments.
Common stock: 3,500,000 shares outstanding, selling for $31 per share; the beta is 1.20.
Preferred stock: 950,000 shares of 6.00 percent preferred stock outstanding, selling for $95
per share and having a par value of $100.
Market: 8.5 percent expected market risk premium; 3.5 percent risk-free rate.
The company has flotation costs of 8.0 percent on new common stock issues; 6.0 percent on new preferred stock issues, and 4.0 percent on new debt issues. The companys tax rate is 23 percent. The project requires $2,900,000 in initial net working capital investment to get operational. Assume the company raises all equity for new projects externally.
- 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.][8 marks]
- 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. [6 marks]
- 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 7), the plant and equipment can be scrapped for $3.25 million. What is the after-tax salvage value of this plant and equipment? [4 marks]
- The company will incur $11,700,000 in annual fixed costs. The plan is to manufacture and sell 12,350 machines per year at $7,200 each; the variable cost of production are $5,450 per machine. What is the annual operating cash flow from this project? [4 marks]
- What is the projects NPV? [Note that the net working capital should be added back at the end of year 5.] [4 marks]
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