Question

2.1. Marshall Industries Limited is a large publicly listed company and is the market leader in vacuum cleaner manufacturing in New Zealand. The company is undertaking a six-year project to set up a manufacturing plant overseas to produce a new line of commercial vacuum cleaners. The company bought a piece of land four years ago for $ 8 million in anticipation of using it for its proposed manufacturing plant. If the company sold the land today, it would receive $ 9.75 million after taxes. In six years, the land can be sold for $14 million after taxes and reclamation costs. The manufacturing plant will cost $275 million to build. The following market data on Marshall Industries Ltd are current: Debt $120,000,000,7.25% coupon bonds outstanding with 20 years to maturity redeemable at par, selling for 95 per cent of par; the bonds have a $1000 par value each and make semi-annual coupon payments. 15,000,000 ordinary shares, selling for $55 per share 12,000,000 shares (par value $ 10 per share) with 6.5% dividends (after taxes), selling for $32 per share Equity Non-redeemable Preference shares The following information is relevant: • Marshall Industries Limited's tax rate is 28% The company had been paying dividends on its ordinary shares consistently. Dividends paid during the past six years is as follows Year (-5) ($) 4.5 Year (-4) ($) 4.7 Year (-3) ($) 5.0 Year (-2) ($) 5.3 Year (-1) ($) 5.5 Year (0) ($) 6.0 • The project requires $ 8.25 million in initial net working capital investment in year zero.

Answer 1

Answer 1.

Project's initial cash flow = Manufacturing plant cost + Opportunity cost of Land + Working Capital

= 275 + 1.75 + 8.25 = $285 Million

Opportunity cost of Land = Selling price as on investment date - Cost of purchase

= 9.75 - 8 = $1.75 Million

Answer 2.

Calculation of Weighted Average Cost of Capital = Cost of Equity*% Equity + Cost of debt*% debt (1-tax rate) + Cost of preferred stock*%preferred stock

= 10*67.60% + 7.25*0.93% (1-0.28) + 6.5*31.47%

= 6.76 + 0.05 + 2.04

= 8.85%

Notes-

1. Calculation of Cost of Equity = D1/P0*100

= 5.5/55*100 = 10%

D1 = Dividend of next year

P0 = Market price of Equity share

2. Calculation of weights

Weight of Equity = Market value of Equity / Total value of Equity, Debt and Preferred stock

= 15,000,000 * 55 / 1220,400,000

= 67.60%

Weight of Debt = Market value of Debt / Total value of Equity, Debt and Preferred stock

= 11,400,000 / 1220,400,000

= 0.93%

Weight of Preferred Stock = Market value of Preferred Stock / Total value of Equity, Debt and Preferred stock

= 384,000,000 / 1220,400,000

= 31.47%

Total value of Equity, Debt and Preferred stock = Market value of Equity+Market Value of Debt+Market value of Preferred stock

= 15,000,000*55 + 120,000*95 + 12,000,000*32

= 1220,400,000

Answer 3.

Calculation of Net Present Value

Year	Initial cost	Sale Proceeds	Variable cost	Fixed Cost	Depreciation	Loss on sale of asset	Cash Flow before Tax	Tax	Cash Flow after tax	Profit on sale of Land	Net cash flow	PV factor @8.85%	Presenet Value
0	-285000000										-285000000	1	-285000000
1		660000000	28500000	250000000	63250000	0	318250000	89110000	229140000		229140000	0.92	210509876
2		660000000	28500000	250000000	47437500	0	334062500	93537500	240525000		240525000	0.84	203003421
3		660000000	28500000	250000000	35578125	0	345921875	96858125	249063750		249063750	0.78	193119097
4		660000000	28500000	250000000	26683593.75	0	354816406.3	99348593.75	255467813		255467813	0.71	181979495
5		660000000	28500000	250000000	20012695.31	0	361487304.7	101216445.3	260270859		260270859	0.65	170326954
6		660000000	28500000	250000000	15009521.48	-23028564	343461914.5	96169336.06	247292578	6000000	253292578	0.60	152283155
Net Present Value													826221998

Notes-

1. Calculation of Depreciation

Year	Cost	Depreciation	WDV
0	253000000
1		63250000	189750000
2		47437500	142312500
3		35578125	106734375
4		26683593.75	80050781
5		20012695.31	60038086
6		15009521.48	45028564

2. Calculation of Loss on sale of Asset

= WDV at the year end of 6 - Sale value

= 45028564 - 22000000

= 23028564

3. Profit on sale of Land

= 14000000 - 8000000

= 6000000

As sale value of Land is given after tax so it is included directly in cash flows after tax.

Calculation of Payback period

Year	Net cash flow	Cumulative cash flow
1	229140000	229140000
2	240525000	469665000
3	249063750	718728750
4	255467813	974196563
5	260270859	1234467422
6	253292578	1487760000

Total cost of project is 285000000 that will be recovered in year 2, so the payback period will be 2 years.

Profitability Index = Present value of future cash flows / Initial Investment

= 1111221998 / 285000000

= 3.90