Q2. Prepare the free cash flow table. Round up to whole numbers.

Project Information

The equipment will cost $880, is expected to have a working life of 4 years, and will be depreciated on a straight-line to a book value of zero.

The equipment is expected to have a salvage value of $150 at the end of 4 years.

The new equipment will improve efficiency and result in increased revenue of $860 in its first year of operation, but because of reduced efficiency from normal wear and tear, revenue will decrease by 5% (from the previous years revenue) for each of the remaining 3 years of the equipments life.

Excluding maintenance, all other costs from operating the equipment will be $200 per year. Maintenance costs will amount to $140 in the equipments first year of operation and will then increase by $10 per year for the remaining 3 years of the equipments life.

The equipment will require additional net working capital of $200. The net working capital will be recovered in full after the equipment is sold at the end of its working life.

The equipment will be installed in a building that is owned by the company but currently is not being used. If the project does not proceed, this building could be rented out for $200 per year.

A feasibility study has been undertaken on the purchase of the new equipment. The cost of preparing the feasibility study was $500.

The company has sufficient capital to undertake all positive-NPV projects. If the Payback Period method is used to evaluate projects, managements policy is that the maximum acceptable payback period is 4 years, and all cash flows in Year 0 would need to be recovered within 4 years for the project to be acceptable under this method.

Notes

The interest rate on the bank loan is 8.8% p.a.

The interest rate on the mortgage loan is 5.7% p.a.

The corporate bonds have a credit rating of BBB+ and have 3 years to maturity. They require semi-annual coupon payments at a coupon rate of 8% p.a.

The ordinary shares are shown on the balance sheet at their book value of $1 per share. They have a beta of 1.2. They are expected to pay a dividend of $0.10 next year. The dividend is expected to grow at a rate of 10% p.a. for the following 4 years and, after that, it will grow at a constant rate of 4% p.a. in perpetuity.

The preference shares have a par value of $1 each and are shown on the Balance Sheet at their par value. They pay a constant dividend of $0.11, and they are currently trading for $1.19.

The market risk premium is 6.7%.

The corporate tax rate is 30%. The 3-year risk-free rate is 2.93%. The 10-year risk-free rate is 3.56%