(a) You are the financial manager of a very profitable firm, which is currently evaluating a new, large investment project at the start of 2020. The project involves the acquisition of a plant, which requires an initial outlay of £300 million. The project's investment horizon is six years. Over this period, the initial capital investment in the plant should be fully depreciated. Despite this, it is expected that at the end of the project (after six years) the taxable salvage value of the plant will amount to £50 million. The project requires an initial (at the start of 2020) working capital investment of £30 million, which should be recovered in full at the end of 2025. Your accountants have put together the following projections on expected sales and cash flows, and information on the cost of capital of the company: Sales EBITD Depreciation EBIT Tax expense EBIAT Table 1. Sales and cash flow projections 2022 140 80 (50) 30 (6) 2020 120 60 (50) 10 (2) 8 Risk-free Rate (Rf) Project Cost of Debt (Rd) Market Risk Premium 2021 135 75 (50) 25 (5) 20 24 Marginal Corporate Tax Rate (Tc) Asset Beta of comparable companies Table 2. Cost of capital 1% 4% 6% 2023 125 65 (50) 15 (3) 20% 0.8 12 2024 120 60 (50) 10 (2) 8 2025 110 50 (50) 0 0 0 Required: Carry out the following calculations, always assuming that cash flows occur at the end of their respective years: (i) Estimate the NPV of the investment project at the start of 2020 if it is 100% financed with equity. Comment on your findings. (ii) Use the WACC method to estimate the NPV of the investment at the start of 2020 assuming that it is financed 40% with equity and 60% with debt and that the financing structure of the project does not change over the life of the project. Comment on your findings. (iii) Show how you could alternatively compute the NPV of part (ii) above by using the APV method rather than the WACC method. (iv) Calculate the NPV of the investment at the start of 2020 assuming that your firm initially borrows £120 million and then pays down the debt at a rate of £20 million per year. Assume that interest payments can always be used to offset the company's taxable profits over the life of the project. Comment on your findings.

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
icon
Related questions
icon
Concept explainers
Topic Video
Question
i) Cost of Equity
Cost of Equity
1% + 0.8(6%)
=
=
= 1% + 4.8%
5.8%
Cashflow
Particulars
Depreciation
Salvage after
tax
=
Initial outlay 300
Working
30
capital
EAT
Add
Working
capital
recovered
Cash flow
Risk freerate + Beta(Market risk premium)
Year O(in
£million)
Year1(in
£million)
8
50
58
year 2(in year 3(in
£million) £million)
20
50
70
24
50
74
year 4(in
£million)
12
50
62
year 5(in
£million)
8
50
58
year 6(in
£million)
0
50
24
30
104
Transcribed Image Text:i) Cost of Equity Cost of Equity 1% + 0.8(6%) = = = 1% + 4.8% 5.8% Cashflow Particulars Depreciation Salvage after tax = Initial outlay 300 Working 30 capital EAT Add Working capital recovered Cash flow Risk freerate + Beta(Market risk premium) Year O(in £million) Year1(in £million) 8 50 58 year 2(in year 3(in £million) £million) 20 50 70 24 50 74 year 4(in £million) 12 50 62 year 5(in £million) 8 50 58 year 6(in £million) 0 50 24 30 104
QUESTION 1
(a) You are the financial manager of a very profitable firm, which is currently evaluating
a new, large investment project at the start of 2020. The project involves the acquisition
of a plant, which requires an initial outlay of £300 million. The project's investment
horizon is six years. Over this period, the initial capital investment in the plant should
be fully depreciated. Despite this, it is expected that at the end of the project (after six
years) the taxable salvage value of the plant will amount to £50 million. The project
requires an initial (at the start of 2020) working capital investment of £30 million, which
should be recovered in full at the end of 2025. Your accountants have put together the
following projections on expected sales and cash flows, and information on the cost of
capital of the company:
Sales
EBITD
Depreciation
EBIT
Tax
expense
EBIAT
Table 1. Sales and cash flow projections
2021
2022
2023
135
140
125
75
80
65
(50)
(50)
30
15
(6)
(3)
12
2020
120
60
(50)
10
(2)
8
Risk-free Rate (Rf)
Project Cost of Debt (Rd)
Market Risk Premium
(50)
25
(5)
20
24
Table 2. Cost of capital
1%
4%
6%
Marginal Corporate Tax Rate (Tc)
Asset Beta of comparable companies
20%
0.8
2024
120
60
(50)
10
(2)
8
2025
110
50
(50)
0
0
0
Required:
Carry out the following calculations, always assuming that cash flows occur at the end
of their respective years:
(i) Estimate the NPV of the investment project at the start of 2020 if it is 100%
financed with equity. Comment on your findings.
(ii) Use the WACC method to estimate the NPV of the investment at the start of
2020 assuming that it is financed 40% with equity and 60% with debt and that the
financing structure of the project does not change over the life of the project.
Comment on your findings.
(iii) Show how you could alternatively compute the NPV of part (ii) above by using
the APV method rather than the WACC method.
(iv) Calculate the NPV of the investment at the start of 2020 assuming that your
firm initially borrows £120 million and then pays down the debt at a rate of £20
million per year. Assume that interest payments can always be used to offset the
company's taxable profits over the life of the project. Comment on your findings.
Transcribed Image Text:QUESTION 1 (a) You are the financial manager of a very profitable firm, which is currently evaluating a new, large investment project at the start of 2020. The project involves the acquisition of a plant, which requires an initial outlay of £300 million. The project's investment horizon is six years. Over this period, the initial capital investment in the plant should be fully depreciated. Despite this, it is expected that at the end of the project (after six years) the taxable salvage value of the plant will amount to £50 million. The project requires an initial (at the start of 2020) working capital investment of £30 million, which should be recovered in full at the end of 2025. Your accountants have put together the following projections on expected sales and cash flows, and information on the cost of capital of the company: Sales EBITD Depreciation EBIT Tax expense EBIAT Table 1. Sales and cash flow projections 2021 2022 2023 135 140 125 75 80 65 (50) (50) 30 15 (6) (3) 12 2020 120 60 (50) 10 (2) 8 Risk-free Rate (Rf) Project Cost of Debt (Rd) Market Risk Premium (50) 25 (5) 20 24 Table 2. Cost of capital 1% 4% 6% Marginal Corporate Tax Rate (Tc) Asset Beta of comparable companies 20% 0.8 2024 120 60 (50) 10 (2) 8 2025 110 50 (50) 0 0 0 Required: Carry out the following calculations, always assuming that cash flows occur at the end of their respective years: (i) Estimate the NPV of the investment project at the start of 2020 if it is 100% financed with equity. Comment on your findings. (ii) Use the WACC method to estimate the NPV of the investment at the start of 2020 assuming that it is financed 40% with equity and 60% with debt and that the financing structure of the project does not change over the life of the project. Comment on your findings. (iii) Show how you could alternatively compute the NPV of part (ii) above by using the APV method rather than the WACC method. (iv) Calculate the NPV of the investment at the start of 2020 assuming that your firm initially borrows £120 million and then pays down the debt at a rate of £20 million per year. Assume that interest payments can always be used to offset the company's taxable profits over the life of the project. Comment on your findings.
Expert Solution
trending now

Trending now

This is a popular solution!

steps

Step by step

Solved in 5 steps with 8 images

Blurred answer
Knowledge Booster
Capital Budgeting
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.
Similar questions
Recommended textbooks for you
Essentials Of Investments
Essentials Of Investments
Finance
ISBN:
9781260013924
Author:
Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:
Mcgraw-hill Education,
FUNDAMENTALS OF CORPORATE FINANCE
FUNDAMENTALS OF CORPORATE FINANCE
Finance
ISBN:
9781260013962
Author:
BREALEY
Publisher:
RENT MCG
Financial Management: Theory & Practice
Financial Management: Theory & Practice
Finance
ISBN:
9781337909730
Author:
Brigham
Publisher:
Cengage
Foundations Of Finance
Foundations Of Finance
Finance
ISBN:
9780134897264
Author:
KEOWN, Arthur J., Martin, John D., PETTY, J. William
Publisher:
Pearson,
Fundamentals of Financial Management (MindTap Cou…
Fundamentals of Financial Management (MindTap Cou…
Finance
ISBN:
9781337395250
Author:
Eugene F. Brigham, Joel F. Houston
Publisher:
Cengage Learning
Corporate Finance (The Mcgraw-hill/Irwin Series i…
Corporate Finance (The Mcgraw-hill/Irwin Series i…
Finance
ISBN:
9780077861759
Author:
Stephen A. Ross Franco Modigliani Professor of Financial Economics Professor, Randolph W Westerfield Robert R. Dockson Deans Chair in Bus. Admin., Jeffrey Jaffe, Bradford D Jordan Professor
Publisher:
McGraw-Hill Education