Andrews plc is financed 50% by equity and 50% by debt capital. The cost of equit
ID: 2806959 • Letter: A
Question
Andrews plc is financed 50% by equity and 50% by debt capital. The cost of equity is 20% and the cost of debt is 14%. The company currently pays out all its profits as dividends and expected dividends are $800,000 a year into the indefinite. A project is under way consideration which would cost $1.2 million. The company’s mix of finance will remain unchanged after the financial results of the project, and the finance needed to fund it, have been taken into account. It would increase annual profits before interest by $340,000. The cost of equity & debt capital would be unchanged. Required: a). ignore tax, calculate WACC for Andrews plc b). what is the NPV of the project? c). by how much would the value of equity increase if the project is undertaken?
Explanation / Answer
Debt Proportion in Andrews Plc = 0.5 or 50% and Equity Proportion in Andrews Plc = 0.5 or 50 %
Taxes are to be ignored which implies that the effective tax rate is zero
Cost of Equity = 20% and Cost of Debt = 14%
(a) Therefore, WACC = 0.5 x Cost of Debt + 0.5 x Cost of Equity = 0.5 x 14 + 0.5 x 20 = 17%
(b) The project is expected to generate additional incomes before interest worth $340000 per annum.
Interest Expense per annum = Project Borrowings x Cost of Debt = 1.2 x 0.14 = $ 0.168 million
Therefore, Annual Cash Flows post interest payment (ACF) = Annual Additional Income - Annual Interest Expense = 0.340 - 0.168 = $ 0.172 million
Also taxes are zero and so would be capital expenditure, net working capital changes and depreciation (the last three items are not mentioned and hence assumed to be zero)
Therefore, Free Cash Flow to Firm (FCFF) generated by the project per annum = ACF = $ 0.172 million
The present value of these additional annual perpetual FCFFs (generated by the new project) would give the amount by which the new project increases the firm's value. The present value would be calculated by discounting the FCFFs at the company's WACC as it is stated that the company's capital structure does not changes post this project's financing and also because the project's financing is included in the company's existing capital structure.
Hence company risk is same as project risk.
Therefore, additional firm value generated = Present Value of Annual Perpetual FCFFs = Additional Annual FCFFs / WACC = $ 0.172 / 0.17 = 1.011764 million
Project NPV = Present Value of FCFFs - Initial Investment = 1.011764 - 1.2 = $ - 0.188 million
(c) Additional firm value created by the new project = Present Value of Annual Perpetual FCFFs = $ 1.011764 million
Since, the firm's capital structure is still 50:50 for debt and equity respectively, half of the additional firm value created would contribute towards increasing existing debt value and the other half towards increasing existing equity value.
Therefore, Increase in Equity Value = $ 1.011764 x 0.5 = $ 0.505882 million OR $ 505882.35