Xentia Technologies Group (XTG) is considering investing in developing new 4D television technology. The CEO of...
Xentia Technologies Group (XTG) is considering investing in developing new 4D television technology. The CEO of XTG, Ms Jane Smith, has appointed you to evaluate the proposal for the board. If the new project goes ahead it is expected that it be operational at the beginning of year 2 (with the first revenues generated by the end of that year). Once the new project is operational it will render the company’s existing 2D technology project obsolete. The new project is then expected to have an operating life of six years.
To assist you in evaluating the project the following information has been prepared:
Existing 2D technology project:
Constant annual earnings before depreciation and taxes (EBDIT) $400,000
Annual depreciation expense on equipment $0
(Equipment fully depreciated)
Annual working capital balance $200,000
(Expected to last in perpetuity)
Expected salvage value of equipment if rendered obsolete $0
New 4D technology project:
New equipment outlays (immediate) $10,000,000
Expected constant EBDIT $3,800,000
(In the first year of operation)
Annual depreciation rate on equipment (straight line) 10% p.a.
Expected salvage value of equipment at the end of the project $3,500,000
Working capital requirement (once project is operational) $300,000
Additional Information:
- Company tax rate is 30%
- Xentia is financed with $25 million in market value of debt and $50 million in market value of equity.
- Xentia has a beta of 1.6.
- Revolutionary Technology Corporation (RTC) is currently using technology that is similar in risk profile to the new 4D project.
- RTC is financed with $40 million in market value of debt and $40 million in market value of equity.
- RTC has a beta of 1.75
- Xentia borrows debt capital at a cost of 8% p.a. compounded semi-annually
- The long term market risk premium (including franking credits) is 9.75% p.a.
- The current yield on Commonwealth Bonds is 4.25% p.a.
- Xentia operates in an imputation tax system.
Required:
- What is the appropriate discount rate that should be used to evaluate the project? Explain your decision.
2. Calculate the NPV of the project. Present the cash flows used in the NPV calculation in a table.
3. Advise whether you should recommend the project. Explain your decision.
Homework Answers
| Ans 1. | ||
| From the RTC data we can find the ungeared beta =betaU | ||
| for the 4D industry that will give the indusry beta. | ||
| For RTC : | ||
| Value of Debt =D=$40M | ||
| Value of Equity =E=$40M | ||
| Tax rate T=30% | ||
| RTC beta =beta G=1.75 | ||
| beta od Debt =betaD =assumed zero | ||
| So betaU= betaG*E/[E+D*(1-T)] +betaD*D*(1-T)/[E+D*(1-T)] | ||
| betaD=0 | ||
| so betaU= 1.75*40/[40+0.7*40] | ||
| betU=1.03 | ||
| So the ungeraed beta for 4D indutry =1.03 | ||
| Using that to find the geared beta of Xentia Technologies | ||
| E =$50M =Equity value of Xentia | ||
| D =Debt value of Xential =$25M | ||
| Tax rate T=30% | ||
| betaU=1.03 | ||
| Assume beta for the investment od Xentia =betaG | ||
| betaG=betaU+(betaU-betaD)*(1-T)*D/E | ||
| as betaD asssumed zero, | ||
| betaG=1.03+1.03*0.7*25/50 | ||
| betaG=1.39 | ||
| So we shall consider the Xentia beta for equity for the 4D | ||
| project as 1.39 | ||
| Risk free rate =4.25% | ||
| Market Risk premium ( with franking credit)=9.75% | ||
| So Cost of Equity =Re=Rf+betaG*Rp | ||
| Re=4.25%+1.39*9.75% | ||
| Re=17.8% | ||
| So cost of equity for Xenita =17.8% | ||
| Cost of Capital for Xenita debt =8% pa compounded semi annually | ||
| EAR =(1+8%/2)^2-1=8.16% pa | ||
| Post Tax cost of Debt =8.16%*(1-30%)=5.71% |
| Calculating WACC | ||||
| Capital Type | Market Value $M | Weightage on Market Value | Post TAx cost | Weighted cost |
| Debt | 25 | 33% | 5.71% | 1.90% |
| Equity | 50 | 67% | 17.80% | 11.87% |
| Total | 75 | 100% | 13.77% | |
| So WACC = Discount rate for the project =13.77% |
| New Eqp cost =$10M | ||
| SL depreciation is 10% , so machine life in 10 years, salvage at the end of 10 yrs not given , | ||
| so assuming annual depreciation $$1,000,000 | ||
| Book value after 6 yrs | 4,000,000 | |
| Salvage value after 6 yrs | 3,500,000 | |
| Capital Loss | 500,000 | |
| Tax saves on Capital Loss @30%= | 150 | |
| Total effective salvage cash flow with tax savings | 3,500,150 |
| NPV Caluclation | Amts in $ | ||||||
| Particulars | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 |
| Initial Investment | |||||||
| New Equipment | (10,000,000) | ||||||
| Incremental Working capital Required ( assuming to be arranged at the end of year 1 , as operations starts in the beginning of yr 2) | (100,000) | ||||||
| Total Initial Investment | (10,000,000) | (100,000) | |||||
| Cash flow from Operations | |||||||
| Incremental EBDIT ($3,800,000-$400,000) | 3,400,000 | 3,400,000 | 3,400,000 | 3,400,000 | 3,400,000 | ||
| Less Incremental Depreciation | 1,000,000 | 1,000,000 | 1,000,000 | 1,000,000 | 1,000,000 | 1,000,000 | |
| EBT | (1,000,000) | 2,400,000 | 2,400,000 | 2,400,000 | 2,400,000 | 2,400,000 | |
| Tax @30% | (300,000) | 720,000 | 720,000 | 720,000 | 720,000 | 720,000 | |
| PAT | (700,000) | 1,680,000 | 1,680,000 | 1,680,000 | 1,680,000 | 1,680,000 | |
| Add Back depreciation | 1,000,000 | 1,000,000 | 1,000,000 | 1,000,000 | 1,000,000 | 1,000,000 | |
| Net Operational cash flow | 300,000 | 2,680,000 | 2,680,000 | 2,680,000 | 2,680,000 | 2,680,000 | |
| Terminal Cash flows | |||||||
| After Tax Salvage value (with Tax saved ) | 3,500,150 | ||||||
| Return of Incremental WC | 100,000 | ||||||
| Total Terminal Cash flow | 3,600,150 | ||||||
| Total Cash flow=a+b+c= | (10,000,000) | 200,000 | 2,680,000 | 2,680,000 | 2,680,000 | 2,680,000 | 6,280,150 |
| PV factor @13.77%=1/1.1377^n | 1 |
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