EITC Ltd is a small shipping company that is considering upgrading its shipping capacity. At present the company owns and operates the Black Pearl as its main ship, but is considering replacing it with a new ship called the Flying Dutchman, a much larger vessel. The CEO of EITC Ltd, Mr Cutler Beckett, has appointed you to evaluate the proposal for the Board. If the Board decides to go ahead with the project the Black Pearl will be immediately sold and replaced by the Flying Dutchman. The Flying Dutchman would then operate for 5 years.

Last year EITC Ltd commissioned the consulting group Swan and Co. to evaluate the potential of the new vessel. This report cost $500,000 and was delivered last month. The finance department of EITC used the findings of that report to provide you with the following information about the two vessels:

Black Pearl

Original purchase price: $15 million

Years since purchase: 5 years

Estimated useful life: 10 years

Depreciation rate: Straight-line to zero

Salvage value this year: $2 million

Salvage value in 5 years: $300,000

Revenue each year: $6.5 million

Operating costs each year: $4.2 million

Flying Dutchman

Purchase price this year: $18 million

Estimated useful life: 10 years

Depreciation rate: Straight Line to Zero

Estimated salvage value in 5 years: $10 million

Revenue each year: $10.8 million

Operating costs each year: $3.5 million

Working capital requirement of the project: $1.5 million

The following additional information is also available about EITC Ltd and the current market:

EITC has $60 million in market value of debt, $30 million in market value of preference shares, and $60 million in market value of ordinary shares.

EITC has an equity beta of 1.4

EITC borrows debt capital at a cost of 6% p.a. above the Commonwealth bond yield

EITCs 10% preference shares have a par value of $2 and are currently trading at $1.25.

The market portfolio is expected to generate a return 15% p.a.

The current yield on Commonwealth Bonds is 6.75% p.a.

The company tax rate is 30%.

Required:

a) What is the appropriate discount rate that should be used to evaluate the project? Explain your decision.

b) Calculate the net cash flows for the project. Present the cash flows in a table and calculate the NPV. Advise whether you should recommend the project.