Cathy Smith from Cathy’s Cool Constructions Pty. Ltd. is considering investing in some equipment to expand her business and has asked for your advice regarding the 2 options she has available, and has given the information below. The company pays a 30% flat rate of company tax.

The current sources of funds and associated costs are as follows:

Source of funds	Value ($)	Cost % before tax
Owners’ Equity (a)	$874,500	10.0%
Mortgage (b)	$525,000	4.0%
Vehicle Loan (c)	$41,000	12.0%

A. Equipment Option 1 costs $50,000, will last 5 years and then become obsolete and be worth nothing. It is expected to bring in approximately $18,000 additional cash revenue each year.

i. Given the current sources of funds and capital structure above, calculate the Weighted Average Cost of Capital for Cathy’s Cool Constructions Pty. Ltd. (6 marks)

Weighted Average Cost of Capital = 6.07%+1.02%+0.24%=7.33%

ii. Using the straight line method of depreciation, calculate the annual depreciation expense. Show your workings (2 marks)

Annual Depreciation expense: $50000/5=$10000

iii. Calculate the additional profit per year after tax and the additional net cash inflow per year. Show your workings. (4 marks)

Additional annual Cash flow           $15600

iv. What is the Average Rate of Return for Option 1? (4 marks)

Average rate of return=5600/50000=11.20%

v. What is the Payback Period (in years) for Option 1? (3 marks)

Payback Period=50000/15600=3.2 years

vi. What is the Net Present Value for Option 1? (10 marks)

   NPV=PV+I= $13401          

B. Equipment Option 2 costs $100,000, will last 8 years and then become obsolete and be worth nothing. It is expected to bring in approximately $35,000 additional cash revenue each year and will require Cathy to take out an additional loan of $50,000, with an interest rate of 12%p.a. before tax.

i. Given the change in sources of funds and capital structure above, calculate the new Weighted Average Cost of Capital for Cathy’s Cool Constructions Pty. Ltd. (6 marks)

WACC

7.3662529

ii. Using the straight line method of depreciation, calculate the annual depreciation expense. Show your workings (2 marks)

Annual Depreciation= (cost of equipment - scrap value )/ life of equipment

=(100000-0)/8=12500

iii. Calculate the additional profit per year after tax and the additional net cash inflow per year. Show your workings. (4 marks)

net operating cash flow

28250

28250

28250

28250

28250

28250

28250

28250

iv. What is the Average Rate of Return for Option 2? (4 marks)

Average rate of return	Average after tax profit/average investment		15750/50000	31.50%
average after tax profit			15750
average investment	100000/2		50000

v. What is the Payback Period (in years) for Option 2? (3 marks)

Payback Period = 100000/28250 = 3.54 years

vi. What is the Net Present Value for Option 2? (10 marks)

NPV= 28250 *5.8866-100000=66296.45

C. Cathy is also concerned about the businesses stability. Cathy advises that the only other liability she has is $55,000 that she owes to Creditors.

i. Using your knowledge of ratios, calculate the debt and equity ratios for the business for both Option 1 and Option 2. Show your workings (2 marks)

ii. Discuss and interpret your ratio analysis. Is there a significant difference in business stability between the two options? (2 marks)

iii. Of the two options, which would you recommend Cathy’s Cool Constructions Pty. Ltd. choose and why? Discuss your reasons fully. (2 marks)

iv. What is meant by the term “the time value of money”? Does this mean that some methods of assessing feasibility of projects are more realistic than others? Discuss and explain, using research to support your argument. (5 marks)

 

Present Value Table Periods Rate per Period 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 18% 20% 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696 0.8475 0.8333 2 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561 0.7182 0.6944 3 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575 0.6086 0.5787 4 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718 0.5158 0.4823 5 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972 0.4371 0.4019 6. 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323 0.3704 0.3349 7 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759 0.3139 0.2791 8. 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269 0.2660 0.2326