Fundanentals of Finance

Finance 6

PROJECT EVALUATION

Fundanentals of Finance

  1. Australian company tax: 30%

  2. Application date for risk – free rate: 09-May-2016

  3. 10 – years risk-free rate: 2.320

  4. 4 – years risk-free rate: 1.625

  5. Credit spread for corporate bonds: 345bp

Weighted average cost of capital

We will need to calculate the proportion for equity and debt in Collinwood Manufacturing Company Ltd. Capital structure.

Current market value of Equity = 1,100,000*7.92 + 400,000*11.63 = $ 13,364,600.

The price of ordinary share is p=D1/(r-g) = $ 7.92

Current market value of Debt = $ 2,000,000

Total market value of Debt and Equity = 2,000,000 + 13,364,600 = $15,364,600.

Weights of Equity = 13,364,600/15,364,600 = 0.86983

Weights of Debts = 2,000,000/15,364,600 = 0.13018

Cost estimation of Equity and after tax costs of Debt.

Equity costs can be estimated using Capital Assets Pricing Model, CAPM or Dividends Discounts Model, DDM.

  1. Cost of preference shares = expected dividends in 1 year/ current stock price + growth rate

= 1.37/11.63 + 0 = 11.7799%

  1. Cost of ordinary shares = risk free rate + Beta * Market risk premium = 1.625 + 1.1*7.6 = 9.985%

  2. Cost of debt = yields to bond maturity: Calculations using excel rate functions yielded: the results from excel we have 10.72%

  3. After tax cost of debt = 10.72 % *(1-30%) = 7.504%

. : WACC = (Equity / Total Capital) * Cost of Equity + (Debt / Total Capital) * Cost of Debt * (1 — Tax Rate)

=(8,712,600/15,364,600)*9.985% + (4,652,000/15,364,600)*11.7799% + (2,000,000/15,364,600)*7.504%

WACC = 10.2%

Circumstances appropriate to use WACC discount rate in evaluating project

WACC is necessary in capital structure like one above since the cost varies with different components used hence the need to determine weights according to respective proportions they represent in capital structure employed by the business (Wilkinson, 2013).

Net present value

Figure 1.

Additional

cummulative

Cashflows

operations

Maintainance

cashflows

cashflows

cashflow

0

(17,000)

recovered

Additional net working capital ($ 1,600) — recovered from scrap value

Rent foregone per year is $ 1,700

Feasibility cost $2,000

Acceptance payback is 4 years.

Salvage value is $ 2,000

cashflows

PVIF(10.2%)

0.907441

8,166.97

0.823449

6,457.49

0.747232

5,032.60

0.678069

4,120.62

23,777.69

From the above data NPV = $ 23,777.69– $ (17,000 +2,000) = $ 4, 777.69

Internal rate of return

From excel function of calculating internal rate of return we have IRR = 11%

cash flows

0

8,166.97

6,457.49

5,032.60

4,120.62

Payback period

cumulative

cashflows

cash flow

Initial outlay cost = $17,000 +$2,000 = $19,000

Payback period is the time required by the project to repay its initial cost incurred

PB = 2 years + (19,000-16,842)/6,735

= 2 years and 3.845 months.

Method to be used in evaluating project

The best method will be the use of NPV which states that for a project to be accepted it should have its NPV greater than zero else be rejected; a positive NPV adds firm wealth (Wilkinson, 2013).

Recommendations

Collinwood Manufacturing Company Ltd. Should therefore go ahead and make investment of purchasing the new equipment since Net present value is positive for the project which is also supported by the payback period of 2years and 3.8 months which is less than maximum acceptable limit by the company of 4 years.

Reference

Wilkinson, J. 2013. Net present value method. (Online) Available at: http://strategiccfo.com/net-present-value-method/> Accessed 9 May 2016.