3 October 2003 FIN2101 BUSINESS FINANCE II MOdULE 9-INTERACTION OF INVESTMENT AND FINANCING DECISIONS QUESTION Briggs Boxing and Packaging Ltd is considering expanding its operations. The expansion project will cost $1 400 000 and will have a 6-year life. It is produce annual before-tax cash inflows of $1 500 000. Before-tax fixed costs estimated to be $400 000 per annum, while before-tax variable costs will be 35% of the estimated cash inflows The firm has a tax rate of 30%, an unlevered opportunity cost of capital of 18%,a cost of debt of 12% and a debt -to-value ratio of 0.25 Should the company undertake the expansion project? QUESTION 2 Termite Ltd is evaluating an expansion project that requires an investment in equipment costing $9 million, with an expected useful life of 5 years. The equipment will be depreciated using the straightline method to zero over its 5-year life. However, it is expected that the equipment will be sold at the end of the 5 years for $1 million The project will increase before-tax net cash inflows by $2.5 million per annum in years 1 and 2, by $4 million per year in years 3 and 4, and by $2 million in year 5 The project is to be partly financed by way of a debt issue to raise $3 million at a cost of 10%. The balance will come from an equity issue, which will incur issue costs of 2% of the gross pro The tax rate is 30% and the cost of equity for an equivalent all-equity financed company is 16% Using the APV approach, should the company proceed with the expansion project? assume that the tax shield on has the same risk as the interest payments themselves
3 October 2003 FIN2101 BUSINESS FINANCE II MODULE 9 – INTERACTION OF INVESTMENT AND FINANCING DECISIONS QUESTION 1 Briggs Boxing and Packaging Ltd is considering expanding its operations. The expansion project will cost $1 400 000 and will have a 6-year life. It is expected to produce annual before-tax cash inflows of $1 500 000. Before-tax fixed costs are estimated to be $400 000 per annum, while before-tax variable costs will be 35% of the estimated cash inflows. The firm has a tax rate of 30%, an unlevered opportunity cost of capital of 18%, a cost of debt of 12% and a debt-to-value ratio of 0.25. Should the company undertake the expansion project? QUESTION 2 Termite Ltd is evaluating an expansion project that requires an investment in equipment costing $9 million, with an expected useful life of 5 years. The equipment will be depreciated using the straightline method to zero over its 5-year life. However, it is expected that the equipment will be sold at the end of the 5 years for $1 million. The project will increase before-tax net cash inflows by $2.5 million per annum in years 1 and 2, by $4 million per year in years 3 and 4, and by $2 million in year 5. The project is to be partly financed by way of a debt issue to raise $3 million at a cost of 10%. The balance will come from an equity issue, which will incur issue costs of 2% of the gross proceeds. The tax rate is 30% and the cost of equity for an equivalent all-equity financed company is 16%. Using the APV approach, should the company proceed with the expansion project? Assume that the tax shield on debt has the same risk as the interest payments themselves
3 October 2003 QUESTION 3 Tipsy Ltd is considering build ing a new hotel that will cost $5 million to establish. It is estimated that the new hotel will generate before-tax annual sales of $2 million The costs of goods sold will be 40% of sales revenue and the company will incur annual marketing and administrative costs of $400 000 before tax. These cash flows are in perpetuity The cost of debt is 11%, the opportunity cost of capital for an all-equity financed firm is 14%, and the firms cost of equity(ks)is 16%. Tipsy has a tax rate of 30% and a target debt-to-value ratio of 0.35 Using the flow-to-equity method, calculate the net present value of the proposed new
3 October 2003 QUESTION 3 Tipsy Ltd is considering building a new hotel that will cost $5 million to establish. It is estimated that the new hotel will generate before-tax annual sales of $2 million. The costs of goods sold will be 40% of sales revenue and the company will incur annual marketing and administrative costs of $400 000 before tax. These cash flows are in perpetuity. The cost of debt is 11%, the opportunity cost of capital for an all-equity financed firm is 14%, and the firm’s cost of equity (ks) is 16%. Tipsy has a tax rate of 30% and a target debt-to-value ratio of 0.35. Using the flow-to-equity method, calculate the net present value of the proposed new hotel
3 October 2003 FIN2101 BUSINESS FINANCE II SOLUTIONSTO TUTORIAL QUESTIONS MODULE 9-INTERACTION OF INVESTMENT AND FINANCING DECISIONS
3 October 2003 FIN2101 BUSINESS FINANCE II SOLUTIONS TO TUTORIAL QUESTIONS MODULE 9 – INTERACTION OF INVESTMENT AND FINANCING DECISIONS
3 October 2003 QUESTION I Step 1- Calculate the Unlevered Cash Flow (UCF) Cash inflows $l500000 Less fixed c 400000 ess Variable costs (35%) Operating income 575000 Less Tax(30%) UCF $402500 Step 2- Calculate ks k,=ko+(1-T)(k0-kd) 0.18+ 0.30)(0.18-0.12 =0.18+0.014 =0.194or194% Step 3-Calculate the wacc D k =k 1-T)× 25 0.194 +0.12×(1-0.30)× =0.1455+0021 0.1665or1665%
3 October 2003 QUESTION 1 Step 1 – Calculate the Unlevered Cash Flow (UCF) Cash inflows $1 500 000 Less Fixed costs 400 000 Less Variable costs (35%) 525 000 Operating income 575 000 Less Tax (30%) 172 500 UCF $ 402 500 Step 2 – Calculate ks ( )( ) ( )( ) 0.194 or 19.4% 0.18 0.014 1- 0.30 0.18 - 0.12 3 1 0.18 1- T k - k E D ks k0 0 d = = + = + = + Step 3 – Calculate the WACC ( ) ( ) 0.1665 or 16.65% 0.1455 0.021 100 25 0.12 1- 0.30 100 75 0.194 V D k 1- T V S ka ks d = = + + = = +
3 October 2003 QUESTION 1(Continued) Step 4-Calculate NPV NPV=$402500× PVIFA $l400000 (s402500×3622)-$140000 $1457855-$1400000 $57855 The project has a positive NPV and should be accepted
3 October 2003 QUESTION 1 (Continued) Step 4 – Calculate NPV ( ) $57 855 $1457 855 - $1400 000 $402 500 3.622 - $1400 000 NPV $402 500 PVIFA0.1665,6 - $1400 000 = = = = The project has a positive NPV and should be accepted
3 October 2003 QUESTION 2 Step 1- Calculate the NPV Assuming All Equity Financed NPV=$2 500000(1-0.30)PVIF A, 162+$4 000 000(1-0. 30)PVIFA, 62 PVIF162 +$20000030)PvF6s+ $9000000 0.30×PV065 +$1000000(1-0.30)PVF155-$900000 =($250000.70×1605)+($4000000×1605×0743) +(2000000030476)+(180000×0.30×3274) +(10000070×0476)-$900000 $2808750+S3339042+$666400+$1767960+$333200-$9000000 -$84648 Step 2- Calculate Pv of financing Side effects PV oftax shield PVA=PMTXPVIFAkn 300000PMT× PVIFAOr05 、$3000000 3.791 =$791348 Year Opening Repayment Interest Principal Ending Principal ComponentComponent Principal 3000000791348 300000 491348 2508652 2508652 250865 40483 1968169 3 1968169 791348 196817 5945311373638 4 1373638791348 137364 653984 719654 719654 791348 71965 719383 271
3 October 2003 QUESTION 2 Step 1 – Calculate the NPV Assuming All Equity Financed ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) - $84 648 $2 808 750 $3339 042 $666 400 $1767 960 $333 200 - $9 000 000 $1000 000 0.70 0.476 - $9 000 000 $2 000 000 0.70 0.476 $1800 000 0.30 3.274 $2 500 000 0.70 1.605 $4 000 000 0.70 1.605 0.743 $1000 000 1- 0.30 PVIF - $9 000 000 0.30 PVIFA 5 $9 000 000 $2 000 000 1- 0.30 PVIF NPV $2 500 000 1- 0.30 PVIFA $4 000 000 1- 0.30 PVIFA PVIF 0.16,5 0.16,5 0.16,5 0.16,2 0.16,2 0.16,2 = = + + + + + + + = + + + + = + Step 2 – Calculate PV of Financing Side Effects a. PV of tax shield $791348 3.791 $3 000 000 PMT $3 000 000 PMT PVIFA PVA PMT PVIFA 0.10,5 k,n = = = = Year Opening Principal Repayment Interest Component Principal Component Ending Principal 1 3 000 000 791 348 300 000 491 348 2 508 652 2 2 508 652 791 348 250 865 540 483 1 968 169 3 1 968 169 791 348 196 817 594 531 1 373 638 4 1 373 638 791 348 137 364 653 984 719 654 5 719 654 791 348 71 965 719 383 271
3 October 2003 QUESTION 2 (Continued) Pv(tax shield)= 300000×0.30$250865×0.30$196817×0.30 1.10 $137364×0.30$71965×0.30 10)(.10)3 =$81818+$62198+$44361+$28146+$13405 =$229928 Issue costs The gross proceeds from the equity issue are Gross proceeds 1-Issue costs 6000000 1-0.02 =$6122449 The issue costs for the equity issue are therefore $122 449 Step 3-Calculate APV APV=-$84648+$229928-$122449 $22831 The project should be accepted - positive APV
3 October 2003 QUESTION 2 (Continued) ( ) ( ) ( ) ( ) ( ) $229 928 $81818 $62198 $44 361 $28146 $13 405 1.10 $71965 0.30 1.10 $137 364 0.30 1.10 $196 817 0.30 1.10 $250 865 0.30 1.10 $300 000 0.30 PV tax shield 4 5 2 3 = = + + + + + + + + = b. Issue costs The gross proceeds from the equity issue are: $6122 449 1- 0.02 $6 000 000 1- Issue costs Net proceeds Gross proceeds = = = The issue costs for the equity issue are therefore $122 449. Step 3 – Calculate APV $22831 APV - $84 648 $229 928 - $122 449 = = + The project should be accepted - positive APV
3 October 2003 QUESTION 3 Step 1-Calculate UCF Cash inflows $2000000 Less cogs (40%) 800000 Less marketing/Admin costs 400000 Operating 800000 Less tax(30%) 240000 $560000 Step 2- Calculate the Value of Debt PV=PⅤ of UCF+(T×D) $560000 0.14+0.30)035×v $4000000 worthdebt 0.895 =$4469274 Debt=$4469274×0.35 $l564246 Step 3-Calculate LCF LCF=UCF-[) XD =$560000 70×0.11×$156424 =$560000-$120447 =$439553 Step 4-Calculate Pv of lCF PV of LCF=S439553 $2747206
3 October 2003 QUESTION 3 Step 1 – Calculate UCF Cash inflows $2 000 000 Less COGS (40%) 800 000 Less Marketing/Admin costs 400 000 Operating income 800 000 Less Tax (30%) 240 000 UCF $560 000 Step 2 – Calculate the Value of Debt ( ) ( )( ) $4 469 274 0.895 $4 000 000 V 0.30 0.35 V 0.14 $560 000 PV PV of UCF T D with debt with debt Levered firm = = = + = + $1564 246 Debt $4 469 274 0.35 = = Step 3 – Calculate LCF ( ) $439 553 $560 000 - $120 447 $560 000 - 0.70 0.11 $1564 246 LCF UCF - 1- T kd D = = = = Step 4 – Calculate PV of LCF $2 747 206 0.16 $439 553 PV of LCF = =
3 October 2003 QUESTION3 (Continued) Step 5-Calculate Amount of Funding From Firms reserves The firm must advance $3 435 754($5 000 000-$1 564 246)from its own reserves Step 6-Calculate NPv NPV=PVof LCF-Investment not borrowed =$2747206-$3435754 $688548 The project should be rejected -negative NPV
3 October 2003 QUESTION 3 (Continued) Step 5 – Calculate Amount of Funding From Firm’s Reserves The firm must advance $3 435 754 ($5 000 000 - $1 564 246) from its own reserves. Step 6 – Calculate NPV - $688 548 $2 747 206 - $3 435 754 NPV PV of LCF - Investment not borrowed = = = The project should be rejected – negative NPV
