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.
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.
FIN2101 BUSINESS FINANCE II
SOLUTIONS TO TUTORIAL QUESTIONS
MODULE 9 – INTERACTION OF INVESTMENT AND FINANCING DECISIONS
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
Step 3 – Calculate the WACC
QUESTION 1 (Continued)
Step 4 – Calculate NPV
The project has a positive NPV and should be accepted.
QUESTION 2
Step 1 – Calculate the NPV Assuming All Equity Financed
Step 2 – Calculate PV of Financing Side Effects
a. PV of tax shield
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
QUESTION 2 (Continued)
b. Issue costs
The gross proceeds from the equity issue are:
The issue costs for the equity issue are therefore $122 449.
Step 3 – Calculate APV
The project should be accepted - positive APV.
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
Step 3 – Calculate LCF
Step 4 – Calculate PV of LCF
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
The project should be rejected – negative NPV.
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.
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.
FIN2101 BUSINESS FINANCE II
SOLUTIONS TO TUTORIAL QUESTIONS
MODULE 9 – INTERACTION OF INVESTMENT AND FINANCING DECISIONS
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
Step 3 – Calculate the WACC
QUESTION 1 (Continued)
Step 4 – Calculate NPV
The project has a positive NPV and should be accepted.
QUESTION 2
Step 1 – Calculate the NPV Assuming All Equity Financed
Step 2 – Calculate PV of Financing Side Effects
a. PV of tax shield
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
QUESTION 2 (Continued)
b. Issue costs
The gross proceeds from the equity issue are:
The issue costs for the equity issue are therefore $122 449.
Step 3 – Calculate APV
The project should be accepted - positive APV.
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
Step 3 – Calculate LCF
Step 4 – Calculate PV of LCF
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
The project should be rejected – negative NPV.
