IAC is looking into the feasibility of the blood pressure monitor. A multidiscip
ID: 2768724 • Letter: I
Question
IAC is looking into the feasibility of the blood pressure monitor. A multidisciplinary group at IAC has come up with the following figures: The project is expected to last 10 years after which IAC will discontinue the blood pressure monitor. Projected annual sales are given in the table below. Year Unit Sales 1 20,000 2 22,000 3 25,000 4 30,000 5 27,000 6 24,000 7 22,000 8 20,000 9 18,000 10 17,000 The new blood pressure monitor will be priced to sell at $299.99 per unit to start and once IAC’s competitors develop similar monitors the price will drop to $249.99 in the fourth year. 3. Cost Projections The new monitor will require $250,000 in net working capital at the start. Subsequently, total net working capital at the end of each year will be 20% of sales for that year. The variable cost per monitor is $60, and total fixed costs are $60,000 per year. The new monitor will require an initial investment in industrial equipment of $1.9 million. The equipment will cost $100,000 to install. The industrial equipment will be sold at the end of the tenth year for about 25% of its cost. IAC will also acquire a new computer network system to replace the existing one. The system will be used to improve communications with customers and within the company. It will also help IAC to monitor the company’s operations more effectively. The cost of the computer system will be $450,000, including installation, and IAC will not sell it at the end of the tenth year. Since the industrial equipment is primarily production machinery, it qualifies as seven- year MACRS property. The computer network system qualifies as five-year MACRS property. The marginal tax rate of the company is 40% The equipment will be installed in an empty warehouse the IAC acquired 5 years ago. At the time IAC paid $250,000 for the warehouse. FINA3383: Managerial Finance Spring 2014 4. Cost of Capital ? Debt: 3,000 6 percent coupon bonds, with 10 years to maturity, and a quoted price of 90. These bonds pay interest quarterly. ? Common stock: 200,000 shares of common stock selling for $30. The stock will pay a dividend of $1.50 next year. The dividend is expected to grow by 5 percent per year indefinitely. The beta of the stock is 1.8. ? Preferred stock: 10,000 shares of 10 percent preferred selling at $80. ? Market: The corporate tax rate is 35 percent, the expected return on the market is 10 percent, and the risk-free rate is 1 percent. 5. Based on this information should IAC proceed? a. Calculate the breakeven point. b. Estimate the pro forma income statements and the project’s cash flows: OCF, Changes in NWC, Changes in Capital Spending, and FCF. c. Calculate the WACC. d. Calculate NPV and explain why the firm should accept or reject the project. e. Calculate IRR and explain why the firm should accept or reject the project. f. Calculate the Payback period. g. Calculate the PI and explain why the firm should accept or the project.Explanation / Answer
Year
1
2
3
4
5
6
7
8
9
10
Unit Sales
$20,000.00
$22,000.00
$25,000.00
$30,000.00
$27,000.00
$24,000.00
$22,000.00
$20,000.00
$18,000.00
$17,000.00
Revenue
$5,999,800.00
$6,599,780.00
$7,499,750.00
$7,499,700.00
$6,749,730.00
$5,999,760.00
$5,499,780.00
$4,999,800.00
$4,499,820.00
$4,249,830.00
Variable Cost
$1,200,000.00
$1,320,000.00
$1,500,000.00
$1,800,000.00
$1,620,000.00
$1,440,000.00
$1,320,000.00
$1,200,000.00
$1,080,000.00
$1,020,000.00
Fixed Cost
$60,000.00
$60,000.00
$60,000.00
$60,000.00
$60,000.00
$60,000.00
$60,000.00
$60,000.00
$60,000.00
$60,000.00
Depreciation (Primary Machinery)
$271,429.00
$465,306.00
$332,362.00
$237,401.00
$169,572.00
$169,572.00
$169,572.00
$84,786.00
$0.00
$0.00
Depreciation (Computer systems)
$90,000.00
$144,000.00
$86,400.00
$51,840.00
$51,840.00
$25,920.00
$0.00
$0.00
$0.00
$0.00
EBT
$4,378,371.00
$4,610,474.00
$5,520,988.00
$5,350,459.00
$4,848,318.00
$4,304,268.00
$3,950,208.00
$3,655,014.00
$3,359,820.00
$3,169,830.00
Tax @ 40%
$1,751,348.40
$1,844,189.60
$2,208,395.20
$2,140,183.60
$1,939,327.20
$1,721,707.20
$1,580,083.20
$1,462,005.60
$1,343,928.00
$1,267,932.00
Net Income
$2,627,022.60
$2,766,284.40
$3,312,592.80
$3,210,275.40
$2,908,990.80
$2,582,560.80
$2,370,124.80
$2,193,008.40
$2,015,892.00
$1,901,898.00
NWC
$1,199,960.00
$1,319,956.00
$1,499,950.00
$1,499,940.00
$1,349,946.00
$1,199,952.00
$1,099,956.00
$999,960.00
$899,964.00
$849,966.00
Recovery of NWC
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$11,919,550.00
After-tax salvage value of Machinery
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$285,000.00
Operating Cash Flow
$1,427,062.60
$1,446,328.40
$1,812,642.80
$1,710,335.40
$1,559,044.80
$1,382,608.80
$1,270,168.80
$1,193,048.40
$1,115,928.00
$13,256,482.00
Depreciation Schedule (Primary Machinery)
Year
Basis
%
Depreciation Expense
Accumulated Depreciation
Book Value
1
$1,900,000.00
14.29%
$271,429.00
$271,429.00
$1,628,571.00
2
$1,900,000.00
24.49%
$465,306.00
$736,735.00
$1,163,265.00
3
$1,900,000.00
17.49%
$332,362.00
$1,069,097.00
$830,903.00
4
$1,900,000.00
12.50%
$237,401.00
$1,306,498.00
$593,502.00
5
$1,900,000.00
8.93%
$169,572.00
$1,476,070.00
$423,930.00
6
$1,900,000.00
8.93%
$169,572.00
$1,645,642.00
$254,358.00
7
$1,900,000.00
8.93%
$169,572.00
$1,815,214.00
$84,786.00
8
$1,900,000.00
4.46%
$84,786.00
$1,900,000.00
$0.00
Depreciation (Computer System)
Year
Basis
%
Depreciation Expense
Accumulated Depreciation
Book ValueTop of Form
1
$450,000.00
20.00%
$90,000.00
$90,000.00
$360,000.00
2
$450,000.00
32.00%
$144,000.00
$234,000.00
$216,000.00
3
$450,000.00
19.20%
$86,400.00
$320,400.00
$129,600.00
4
$450,000.00
11.52%
$51,840.00
$372,240.00
$77,760.00
5
$450,000.00
11.52%
$51,840.00
$424,080.00
$25,920.00
6
$450,000.00
5.76%
$25,920.00
$450,000.00
$0.00Bottom of Form
Cost of Capita:
Cost of Debt: It is the after tax YTM of the bond.
YTM of the bond:
Bond Value = C {[1-(1+(YTM))-t/(YTM)] + [F / (1+ (YTM))t]
B0 = $90
C = $100 x 6% = $6
F = $100
YTM = the yield to maturity on the bond
t = 10
$90 = $6 {[1-(1+(YTM))-2/(YTM)] + [$100 / (1+ (YTM))2]
YTM= 7.45%
After-tax YTM = 7.45% x (1-tax rate) => 7.45% x 0.65 = 4.8425%
Value of the bond = 3,000 x $90 = $270,000
Cost of Equity:
Cost of equity is the required rate of return as per CAPM model:
Required Rate of return = Rf + Beta*(Rm – Rf)
=> 1% + 1.8*(10% - 1%) = 17.2%
Intrinsic value of one share = Dividend / (Ke – G) => $1.5/(17.2% - 5%) = $12.295
Value of equity = $12.295 x 200,000 = $2,459,000
Cost of preferred equity = 10%
Value of preferred equity = $80 x 10,000 = $800,000
Total Capital = $270,000 + $2,459,000 + $800,000 = $3,529,000
Weight of Debt = $270,000/$3,529,000 = 7.65%
Weight of Equity = $2,459,000/$3,529,000 = 69.68%
Weight of Preferred Stock = $800,000/$3,529,000 = 22.67%
WACC = (7.65% x 4.8425%) + (69.68% x 17.2%) + (22.67% x 10%) = 14.62%
Break Even Point: Fixed Cost / (Sales price per unit – Variable cost per unit)
From Year 1 to 4: $60,000 / ($299.99 - $60) = 250 Units
From Year 5 onwards: $60,000 / ($249.99 - $60) = 316 units
NPV = -$2,950,000 + [($1,427,062.60)/(1.1462)] + [($1,446,328.40)/(1.1462)2] + [($1,812,642.80)/(1.1462)3] + [($1,710,335.40)/(1.1462)4] + [($1,559,044.80)/(1.1462)5] + [($1,382,608.80)/(1.1462)6] + [($1,270,168.80)/(1.1462)7] + [($1,193,048.40)/(1.1462)8] + [($1,559,044.80)/(1.1462)9] + [($1,559,044.80)/(1.1462)10] = $7,591,424.25
As the NPV is positive, we should accept the project.
IRR:
0 = -$2,950,000 + [($1,427,062.60)/(IRR)] + [($1,446,328.40)/(IRR)2] + [($1,812,642.80)/(IRR)3] + [($1,710,335.40)/(IRR)4] + [($1,559,044.80)/(IRR)5] + [($1,382,608.80)/(IRR)6] + [($1,270,168.80)/(IRR)7] + [($1,193,048.40)/(IRR)8] + [($1,559,044.80)/(IRR)9] + [($1,559,044.80)/(IRR)10] = 53.4914%
As the IRR is greater than the cost of capital, we should accept the project.
Payback Period:
Amount recovered in 2 years = $1,427,062.60 + $1,446,328.40 = $2,873,391
Amount to be recovered in Year 3 = $2,950,000 - $2,873,391 = $76,609
Payback Period = 2 Years + ($76,609/$1,710,335.40) = 2.0448 Years
Profitability Index = PV of future cash flows / Initial Investment
=> $10,541,424.25/$2,950,000 = 3.5733
The PI index tells us that the project should be accepted as it will result in 3.5733 times of initial investment.
Year
1
2
3
4
5
6
7
8
9
10
Unit Sales
$20,000.00
$22,000.00
$25,000.00
$30,000.00
$27,000.00
$24,000.00
$22,000.00
$20,000.00
$18,000.00
$17,000.00
Revenue
$5,999,800.00
$6,599,780.00
$7,499,750.00
$7,499,700.00
$6,749,730.00
$5,999,760.00
$5,499,780.00
$4,999,800.00
$4,499,820.00
$4,249,830.00
Variable Cost
$1,200,000.00
$1,320,000.00
$1,500,000.00
$1,800,000.00
$1,620,000.00
$1,440,000.00
$1,320,000.00
$1,200,000.00
$1,080,000.00
$1,020,000.00
Fixed Cost
$60,000.00
$60,000.00
$60,000.00
$60,000.00
$60,000.00
$60,000.00
$60,000.00
$60,000.00
$60,000.00
$60,000.00
Depreciation (Primary Machinery)
$271,429.00
$465,306.00
$332,362.00
$237,401.00
$169,572.00
$169,572.00
$169,572.00
$84,786.00
$0.00
$0.00
Depreciation (Computer systems)
$90,000.00
$144,000.00
$86,400.00
$51,840.00
$51,840.00
$25,920.00
$0.00
$0.00
$0.00
$0.00
EBT
$4,378,371.00
$4,610,474.00
$5,520,988.00
$5,350,459.00
$4,848,318.00
$4,304,268.00
$3,950,208.00
$3,655,014.00
$3,359,820.00
$3,169,830.00
Tax @ 40%
$1,751,348.40
$1,844,189.60
$2,208,395.20
$2,140,183.60
$1,939,327.20
$1,721,707.20
$1,580,083.20
$1,462,005.60
$1,343,928.00
$1,267,932.00
Net Income
$2,627,022.60
$2,766,284.40
$3,312,592.80
$3,210,275.40
$2,908,990.80
$2,582,560.80
$2,370,124.80
$2,193,008.40
$2,015,892.00
$1,901,898.00
NWC
$1,199,960.00
$1,319,956.00
$1,499,950.00
$1,499,940.00
$1,349,946.00
$1,199,952.00
$1,099,956.00
$999,960.00
$899,964.00
$849,966.00
Recovery of NWC
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$11,919,550.00
After-tax salvage value of Machinery
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$285,000.00
Operating Cash Flow
$1,427,062.60
$1,446,328.40
$1,812,642.80
$1,710,335.40
$1,559,044.80
$1,382,608.80
$1,270,168.80
$1,193,048.40
$1,115,928.00
$13,256,482.00