Please list all your working (on a piece of paper - not excel output). Thank you

ID: 2616916 • Letter: P

Question

Please list all your working (on a piece of paper - not excel output). Thank you!!

Question 2 (30 marks) Xentia Technologies Group (XTG) is considering investing in developing new 4D television technology. The CEO of XTG, Ms Jane Smith, has appointed you to evaluate the proposal for the board. If the new project goes ahead it is expected that it be operational at the beginning of year 2 (with the first revenues generated by the end of that year). Once the new project is operational it will render the company's existing 2D technology project obsolete. The new project is then expected to have an operating life of six years. To assist you in evaluating the project the following information has been prepared: Constant annual earnings before depreciation and taxes (EBDIT) Annual depreciation expense on equipment (Equipment fully depreciated) Annual working capital balance Expected salvage value of equipment if rendered obsolete $400,000 $0 $200,000 $0 4 New equipment outlays (immediate) Expected constant EBDIT (In the first year of operation) Annual depreciation rate on equipment (straight line) Expected salvage value of equipment at the end of the project Working capital requirement (once project is operational) $10,000,000 $3,800,000 10% pa. $3,500,000 $300,000

Explanation / Answer

1. Cost of Borrowing for Xentia is given as 8% p.a

So, Kd = 8% ( 1- Tax Rate) = 5.6% p.a

The Beta of RTC should be used because it has similar risk profile to the new 4D project

Cost of Equity of Xentia can be calculated using Capital Asset Pricing Model-

Ke = Rf + (Rm - Rf)Beta = 4.25 + (9.75 - 4.25) x 1.75 = 13.88%

WACC of Xentia = Debt weightage x Kd + Equity Weightage x Ke

= 1/3 x 5.6 + 2/3 x 13.88 = 11.12%

Therefore, appropriate discount rate used to evaluate the project should be 11.12% p.a

Particulars

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

EBIDT

3800000

Depreciation(10% of (10000000 - 3500000))

1083333

Profit after Depreciation

-1083333

2716667

Tax @ 30%

815000

PAT

-1083333

1901667

Add Back Depreciation

1083333

Cash Flow after Tax

2985000

Salvage at end of year 6

3500000

After tax Cashflows foregone of 2D project

-280000

Initial Investment

-10000000

Net Working capital required (300000-200000)

-100000

Net Cash Flows

2605000

2705000

6205000

Pulled @ Discount rate of 11.12%

-10000000

2109712

1971472

1774183

1596637

3296009

As the 2D project will become obselete, the Working capital of 2 Lac will be recovered in year 2 & therefore additional working required will be 1 Lac.

Cash flows of 2D project will be scarificed for the new project , so it is the opportunity cost for the new project which has been considered for calculating NPV

NPV of the project = Sum of Total Cash flows - Initial investment = 10748013 - 10000000 = 748013

3. As the NPV appears positive, investment is recommended and also new technology is always an edge over competitors in the market , so we should go for the project

Particulars

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

EBIDT

3800000

Depreciation(10% of (10000000 - 3500000))

1083333

Profit after Depreciation

-1083333

2716667

Tax @ 30%

815000

PAT

-1083333

1901667

Add Back Depreciation

1083333

Cash Flow after Tax

2985000

Salvage at end of year 6

3500000

After tax Cashflows foregone of 2D project

-280000

Initial Investment

-10000000

Net Working capital required (300000-200000)

-100000

Net Cash Flows

2605000

2705000

6205000

Pulled @ Discount rate of 11.12%

-10000000

2109712

1971472

1774183

1596637

3296009

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