GROUP A

Toy and Novelty Company (TNC) is evaluating an investment project that has several financing side effects. The project involves establishing a facility to assemble children's toys in a sparsely populated area of northern Ontario, in response to a mandate of the federal government to support employment in the region. The facility has an expected useful life of 15 years. It would require an initial investment of $10,000,000. Of this amount, $8,500,000 would be for equipment with a 20% CCA rate and the remainder of the purchase price would be for the land and building. Assume no CCA is allowed for the land or for this building. There is no salvage value for the equipment, but the land and building can be sold to the federal government for a guaranteed price of $1,500,000 in 15 years. The CCA class would be closed after the 15-year period.

Annual revenues are expected to be $4,000,000 and annual variable cost, if the facility is financed with retained earnings, are estimated at $2,500,000. In order to provide incentives to firms, the federal government is offering a subsidy for operating costs, to a maximum of $250,000 per year for 15 years. The $250,000 represents before-tax savings and these are taxable. The company has a tax rate of 40% and is currently financed with all equity. The required return on shareholders equity is now 15%.

Suppose that TNC would finance this investment with $5,000,000 of new debt with an interest cost of 6% per annum and $5,000,000 of newly issued shares. Flotation costs for both would total $350,000. These costs can be amortized over a 5-year period on a straight-line basis. The debt would be issued for a 15-year term and would pay annual interest only, with all principal to be repaid at maturity.

Required:

Calculate the adjusted present value (APV) of this investment proposal. Determine whether the proposal should be accepted, and briefly explain why.

Initial investment- 10,000,000

Equipment- 8,500,000

Salvage Value - 1,500,000

N- 15 years

ITC- 250,000 per year

Net Cash flow= 4,000,000- 2,500,000

= 1,500,000

Tax Rate = 40%

I/R= 15%

5,000,000 of new debt

Kd 6%

$5,000,000 of new shares

Flotation cost is 350000 over 5 years