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Section C Answer the follow-mg question..- Question 6 Delaney Pumps manufactures and distributes an extensive line of agricultural irrigation sys tems. In recent. years. computerized control systems used to automate irrigation and to conserve water have becolne increasingly important in selling high-end systems. Delaney management. is thus considering investing $160 million to develop a statcLofthe.~irtl computerized controller that promises to leapfrog mmpetition. Development. work would be contracted to a software development company on a costplus basis. Revenue would come from a new product line fea turing the controller and from license fees from selected competitors who elected to include the controller in their products. Projected cashflows for the investment. are given in the following table: Year 0 i 2 3 4 EBlT $50.0 $150.0 $80.0 $30.0 Expected FCF' 3(1000} 30.0 120.0 00.0 70.0 The projections extend for only -1 yeais because management anticipates that other. more advanced controllers will be available by this time. Two clmllenges confronted Delaney's management as they began their deliberations. 1. Because the digital controller appeared much now than the company's usual capital expenditures. managers chose to use a hurdle rate which was higher than the usual 10%. The treasurer reasoned that the digital controller would be an average risk pmject for software companies, and identied ve smaller, publicly traded Iirms specializing in busi ness automation smftware. By unlevering their equity betas. she estimated the industry asset beta to be if = 2.41. 2. Delaney had traditionally nanced its business with the goal of maintaining a target times interest-earned ratio of 3 to l ftiInes-interestearned ratio = EBITfInterest Expenditure). But since this project consisted almost. entirely of intangible colnputer code and because its cash ows were quite uncertain. Delaney's treasurer thought. it prudent to target a higher interest. coverage of 10 to 1. Delaney's treasurer chooses to evaluate the project. using the APV method. Given the above information: [a} Compute the unlevered cost of capital for Delaney's project. knowing that. the riskfree rate of interest is 4.2% and that the market risk premium is 0.4%. Use m to discount the free cash ows in the above table, and compute the project NPV assuming allequity nancing. (b) Given a timesinterestearned target ratio on this project. of 10 to 1. the annual interest. on which the project can claim tax shields is 1f10 of its EBIT for the next 4 years. Assume a 40% corporate tax rate and compute the interest tax shields implied by the project. {c} Answer the following two questions: Continued on next page. .. (i) The present. value of tax shields should reect. the risk of the cash ows that. are being discounted. Given that in this case their amount is tied mechanically to operating income. they share the risk of the project. Wlud is the appropriate discount rate for the tax shield.r Which rate would have been more appropriate if Delaney had chosen to x the amount of debt independently of the projected EBIT'.' (ii) Should Delaney invest in the project'.' 36 marks