Wheel Industries is considering a three-year expansion project, Project A. The project requires an initial investment of $1.5 million. The project will use the straight-line depreciation method. The project has no salvage value. It is estimated that the project will generate additional revenues of $1.2 million per year before tax and has additional annual costs of $600,000. The Marginal Tax rate is 35%.
Required:
Wheel has just paid a dividend of $2.50 per share. The dividends are expected to grow at a constant rate of six percent per year forever. If the stock is currently selling for $50 per share with a 10% flotation cost, what is the cost of new equity for the firm? What are the advantages and disadvantages of using this type of financing for the firm?
The firm is considering using debt in its capital structure. If the market rate of 5% is appropriate for debt of this kind, what is the after tax cost of debt for the company? What are the advantages and disadvantages of using this type of financing for the firm?
The firm has decided on a capital structure consisting of 30% debt and 70% new common stock. Calculate the WACC and explain how it is used in the capital budgeting process.
Calculate the after tax cash flows for the project for each year. Explain the methods used in your calculations.
If the discount rate were 6 percent calculate the NPV of the project. Is this an economically acceptable project to undertake? Why or why not?
Now calculate the IRR for the project. Is this an acceptable project? Why or why not? Is there a conflict between your answer to part C? Explain why or why not?
To answer these questions, we need to perform several calculations and understand some concepts. Let's go step by step:
1. Cost of new equity:
To calculate the cost of new equity, we need to use the dividend growth model. The formula is as follows:
Cost of Equity = (Dividend per Share / Current Stock Price) + Growth Rate of Dividends
Given:
Dividend per Share = $2.50
Current Stock Price = $50
Growth Rate of Dividends = 6%
Cost of Equity = ($2.50 / $50) + 0.06 = 0.05 + 0.06 = 0.11 or 11%
Advantages of using new equity financing:
- It does not create any financial obligations or interest payments.
- It allows the company to keep full control over its operations.
Disadvantages of using new equity financing:
- Dilution of existing shareholders' ownership.
- Higher cost compared to debt financing.
2. After-tax cost of debt:
To calculate the after-tax cost of debt, we need to consider the tax rate and the market rate of debt.
After-tax Cost of Debt = Pre-tax Cost of Debt x (1 - Tax Rate)
Given:
Pre-tax Cost of Debt = 5%
Tax Rate = 35%
After-tax Cost of Debt = 5% x (1 - 0.35) = 5% x 0.65 = 3.25%
Advantages of using debt financing:
- It usually offers lower costs compared to equity financing.
- Interest payments on debt are tax-deductible.
Disadvantages of using debt financing:
- It increases financial risk and the potential for bankruptcy.
- It may limit the company's financial flexibility.
3. Weighted Average Cost of Capital (WACC):
WACC is the average cost of the company's capital sources (debt and equity) weighted by their respective proportions in the capital structure. The formula is as follows:
WACC = (Weight of Debt x After-tax Cost of Debt) + (Weight of Equity x Cost of Equity)
Given:
Debt Weight = 30%
Equity Weight = 70%
WACC = (0.30 x 3.25%) + (0.70 x 11%) = 0.975% + 7.7% = 8.675% or 8.68%
WACC is used in the capital budgeting process to discount the expected future cash flows of the project. It represents the minimum required rate of return for the company to undertake the project.
4. After-tax cash flows for the project:
To calculate the after-tax cash flows, we need to subtract the annual costs from the additional revenues and apply the tax rate. The formula is as follows:
After-tax Cash Flow = (Additional Revenues - Additional Costs) x (1 - Tax Rate)
Given:
Additional Revenues = $1.2 million
Additional Costs = $600,000
Tax Rate = 35%
Year 1:
After-tax Cash Flow = ($1.2 million - $600,000) x (1 - 0.35) = $600,000 x 0.65 = $390,000
Years 2 and 3 (assuming constant):
After-tax Cash Flow = ($1.2 million - $600,000) x (1 - 0.35) = $390,000
5. Net Present Value (NPV) calculation:
The NPV represents the present value of expected cash flows discounted at the project's required rate of return (WACC). The formula is as follows:
NPV = PV(Cash Flows) - Initial Investment
Given:
Discount Rate = 6%
Year 1:
PV(Cash Flow) = $390,000 / (1 + 0.06) = $367,924.53
Year 2:
PV(Cash Flow) = $390,000 / (1 + 0.06)^2 = $346,537.57
Year 3:
PV(Cash Flow) = $390,000 / (1 + 0.06)^3 = $326,904.22
NPV = $367,924.53 + $346,537.57 + $326,904.22 - $1.5 million = -$458,633.68
Since the NPV is negative, the project is not economically acceptable. The negative NPV indicates that the project's expected cash flows are not sufficient to cover the initial investment and the required rate of return.
6. Internal Rate of Return (IRR) calculation:
IRR is the discount rate that equates the present value of cash inflows with the present value of cash outflows (initial investment). We can use a financial calculator or spreadsheet software to find the IRR.
Given the cash flows: -$1.5 million, $390,000, $390,000, $390,000
IRR = 5.16%
Whether this project is acceptable or not depends on the company's required rate of return. If the required rate of return is lower than the IRR (5.16%), then the project would be acceptable. If the required rate of return is higher, it would not be acceptable.
There is no conflict between the answers to part C because the NPV and IRR use different approaches to evaluate the project's profitability. NPV considers the actual amounts of cash flows and their timing, while IRR focuses on the project's internal rate of return, independent of the required rate of return.