Question

that will be fantastic during the net Avco Company is considering a project for a fad product four years, but obsolete after four years . The accounting department províded the expected free cash flow from this project Year Incremental Earnings Forecast iS million) 1 Sales O 00 000 6000 ssoo Cost of Goods Sold 3 2 Gross Profit 3500 3600 3500 3600 5 Depreciation 6 EBIT 7 Income Tax at 40% 8 Unlevered Net Income 667 2000 2000 200 (4.00, 12.00 12.00 1200 12.00 Free Cash Flow 9 Plus: Depreciation 00 600 600 600 10 Less: Capital Expenditures 11 Less: Increases in NVWC 2 Free Cash Flow 0400 28.00) 18.00 18.001 The market risk of this project is similar to that for this company's other lines of business Avco's current market value balance sheet and equity and debt cost of capital were provided as follows: Assets Liabilities 20 Debt Debe Cash Existing Assets 600 Equity 320 300 - Total Assets 620 Liabilities 620 and Equity Avco will maintain a constant (net) debt-equity ratio, including any financing related to this project Avco decides to spend its $20 million in cash to fund this project and borrow an addtional $10.625 million. Avco will pay the remaining $2.625 million to shareholders through a dividend · Questions:

Answer 1

Answer 1a)

Cash	20
Existing assets	600
Total Assets	620
Debt	320
Equity	300
Total Capital	620
Cost OF debt	6%
Cost of Equity	10%
WACC = Cost of Equity* Equity / Total Capital + Cost of debt * Debt * (1-tax rate)/Total Capital
WACC =	6.70%

Answer 1b)

Year		0	1	2	3	4
Sales		-	60	60	60	60
COGS		-	(25)	(25)	(25)	(25)
Gross Profit		-	35	35	35	35
OPEX		(7)	(9)	(9)	(9)	(9)
Depreciation		-	(6)	(6)	(6)	(6)
EBIT		(7)	20	20	20	20
Tax @ 40%		3	8	8	8	8
Unlevered Net Income		(4)	12	12	12	12
FCF
Depreciation		-	6	6	6	6
Capex		(24)	-	-	-	-
Inc in NWC		-	-	-	-	-
FCF		(28)	18	18	18	18
Discount Factor		1/(1+wacc)	1/(1+wacc)^2	1/(1+wacc)^3	1/(1+wacc)^4	1/(1+wacc)^5	WACC = 6.7%
Discount Factor		0.94	0.88	0.82	0.77	0.72
Discounted FCF		(26.24)	15.81	14.82	13.89	13.02
Present value of FCF	= sum of discounted FCF		31.29
NPV	$31.29

Answer 1c) Since this is a NPV positive project, its value creating and should be undertaken in absence of any better utilization of resources.

Answer 2)

Balance Sheet		Start	Current Market Value Balance Sheet
Cash		20	-	Cash 20, used for the project
Existing assets, at start of year		600	600
Capex		-	28	Capex for the new project
Total Assets		620	628
Debt		320	330.625	Additional debt raised - 10.625
Equity at start of year		300	300.000
Less: Dividends			(2.625)	Portion of debt used for dividends to equity holders
Total Capital		620	628

Answer 3)

Year	Start	0	1	2	3	4
Unlevered Net Income		(4)	12	12	12	12
Interest Exp @ Cost of Debt on new Debt		0.6375	0.6375	0.6375	0.6375	0.6375
Net Income		(4.638)	11.363	11.363	11.363	11.363
Equity	300	300	297.9875	309.35	320.7125	332.075
Less: Dividend		2.625
Add: Retained Earnings		(4.638)	11.363	11.363	11.363	11.363
Closing Value of Equity	300	297.9875	309.35	320.7125	332.075	343.4375
Debt	320	330.625	330.625	330.625	330.625	330.625
Debt to Equity	1.07	1.10	1.11	1.07	1.03	1.00
Debt Capacity		0	0	0	11.87	24.40

Note: Have solved for more than 1st 4 parts, as in line with HOMEWORKLIB POLICY if there are multiple questions