Question

Worldwide Medical Devices (WMD) manufactures medical diagnostic equipment at several locations across Europe. WMD has traditionally manufactured high-quality large medical equipment for use in hospitals. Recently, the firm has developed a new technology that makes testing vitamin D deficiency at GP surgeries affordable, avoiding the need to send patients’ blood to testing laboratories. WMD has spent £50m designing and developing this new generation of equipment for the European domestic market. The costs to complete the final stages of regulatory approval are estimated to be £30m. WMD plan to establish a new division, Fast Medical Diagnostics (FMD), to manufacture and market this new generation of testing devices. This will be WMD’s first venture into the smaller equipment market. WMD will continue to manufacture their larger hospital equipment separately.

This new generation of testing devices is expected to have a production life of six years. The Group Finance Director is busy arranging a new debtfacility for WMD and has asked you to prepare an investment appraisal report to present to the next board meeting which will make a recommendation to the directors whether to proceed with establishing FMD.

The new FMD factory would be built on a vacant site already owned by WMD adjacent to their existing Lyon factory. The vacant site was recently valued at £6m. Investment to build the factory and the required plant and equipment would be £300m. WMD charges depreciation on a straight-line basis over the useful life of assets. The plant and equipment is not expected to have any scrap value at the end of the project. The project will also require additional working capital of £60m for the life of the project. It is expected that 60% of the working capital investment will be recovered at the end of the project.

Currently, net investment in plant and equipment is eligible for capital allowances on a straight-line basis over four years. The applicable corporation tax rate is 30% and paid one year in arrears. Capital allowances are received by WMD in the same year that they are claimed.

FMD expects to sell a total of 100,000 of the devices each year at a fixed price of £3,200 per device over the planned production life of six years. Incremental operating costs for FMD are estimated to be £220m per annum. All cash flows are in today’s money and inflation is expected to be 2.5% per annum over the next six years.

WMD’s shares continue to be listed on the London Stock Exchange where they currently trade at £3.50 with an equity beta of 1.6. The expected equity risk premium is 8% and risk-free rate is 2%. WMD currently has a market gearing ratio (debt / [debt+equity]) of 30%. WMD has sufficient resources available to fund the FMD project from current facilities. The current average before-tax cost of borrowing for the company is 5%.

You are required to:

a.Estimate the weighted average cost of capital (WACC) for WMD.

b.Carry out a discounted cash flow (DCF) analysis of the project based on the information given and calculate the net present value (NPV), internal rate of return (IRR) and the payback period of the project. Discuss and justify your chosen discount rate. If the discount rate you use in your DCF analysis differs from the WACC estimated in part (a), explain why.

Another person attempted this question but did not take into account the capital allowance and the 6million opportunity cost. I did not understand why.

Answer 1

Weighted average cost of capital for WMD is

Cost of equity = Risk free rate of return + Beta × (market rate of return – risk free rate of return)

Cost of equity = 2% +1.6 x (8%) = 15%

Cost of Debit = Pre Tax Cost of Debit (1-tax rate)

Cost of debit = 5% x (1-30%) = 3.5%

Weight of Debit in Capital Structure is 0.3 and Equity is 0.7

WACC = (Equity/Total Capital)* Cost of Equity + (Debit / Total Capital)* Cost of Debit after tax

WACC = 10.5% + 1.1% = 11.6%