QUESTION 2: WEIGHTED AVERAGE COST OF CAPITAL (60 Marks) 2.1. Darwin Enterprises is a large, publicly listed company and is the market leader in manufacturing dehumidifiers. The company is looking to set up a manufacturing plant overseas to produce a new line of residential dehumidifiers. This will be a six-year project. The company bought a piece of land four years ago for $ 8 million in anticipation of using it for its proposed manufacturing plant. If the company sold the land today, it would receive $ 10.25 million after taxes. In six years, the land can be sold for $11.5 million after taxes and reclamation costs. Darwin Enterprises wants to build a new manufacturing plant on this land. The Plant will cost $295 million to build. The following market data on Darwin's securities are current: 0 Debt $120,000,000,6.25% coupon bonds outstanding with 20 years to maturity redeemable at par, selling for 95 per cent of par; the bonds have a $1000 par value each and make semi-annual coupon payments. Equity 15,000,000 ordinary shares, selling for $55 per share Non-redeemable 12,000,000 shares (par value $ 10 per share) with 6.5% dividends (after Preference shares taxes), selling for $32 per share Additional Information: Darwin Enterprises' tax rate is 28%. The project requires $ 8.5 million in initial net working capital in year 0 to become operational. The company had been paying dividends to its ordinary shareholders consistently. Dividend information for the past five years is as follows: Year (-4) ($) Year (-3) ($) Year (-2) ($) Year (-1) ($) Year (0) ($) 4.6 4.8 5.2 5.3 5.9 The manufacturing plant has a ten-year tax life, and the company uses Diminishing value method of depreciation at 25% per annum for the Plant. At the end of Year 6, the Plant can be scrapped for $ 52 million. The company estimations show that 280,000 dehumidifiers are manufactured and sold per year (Years 1-6) and selling price per unit in year one is $2,100, but the price will increase by 2% per year. Similarly, the variable costs per unit are expected to be $900 for year one but will increase by 2.5% per year in the subsequent periods. The project will incur $220 million per annum in fixed costs (fixed costs includes coupon payments to bondholders). At the end of year 6, the company will sell the land. Required: 1. Calculate the project's initial, (time 0) cash flows (4 MARKS) 2. Compute the weighted average cost of capital (WACC) of Darwin Enterprises. Show all workings and state clearly the assumptions underlying your computations. (16 MARKS) 3. Using the WACC computed in part (2) above, calculate the project's: a) Net Present Value (NPV), b) Internal Rate of Return (IRR) c) Profitability Index (PI), d) Payback period, and e) Discounted payback period (use WACC as the discount rate) Note: Work all solutions to the nearest two decimals, show depreciation table, calculate gain/loss on the sale of Plant, and Land. Record tax effects in the income statement. 4. Make a recommendation about whether Darwin Enterprises should go ahead with this project. Justify your recommendation explaining why or why not. (40 MARKS)
