NEW ECONOMY TRANSPORT
Principles of Corporate Finance
7th Edition
Richard A. Brealey and Stewart C. Myers
This is an equipment replacement decision. The objective is to minimize the present value of future costs. But there are a few real-life complications.
• Some cash flows are stated in real terms, some in nominal terms. We will use a real discount rate for the real cash flows, a nominal rate for the nominal flows. The alternative is to convert all cash flows to real terms (using a real discount rate) or all to nominal (using a nominal rate).
• The new boat lasts longer (20 years) than the rehabilitated Vital Spark (15 years). Thus we calculate equivalent annual costs. The alternative analysis
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Operating costs and additional revenues are taken at mid-year.
11. Long-term expected inflation is 3%.
12. Using a NETCO “risk premium” of 10% and the 6% T-bond rate, the nominal opportunity cost of capital for NETCO is 16%.
13. Using the assumed long-term inflation rate of 3%, the real opportunity cost of capital for NETCO is:
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Analysis
Table 1 tabulates cash flows based on these assumptions.
Table 2 shows equivalent annual cost. The rehabilitated Vital Spark wins, but its margin over the new boat is small. Perhaps the new boat 's other attributes (better new accommodations, higher abandonment value[1]) should carry the day.
Table 3 shows a present-value analysis with a terminal value for the new boat entered at year 16. The new boat is slightly more expensive than the rehabilitated Vital Spark.
The spreadsheet used to generate the tables is attached.
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|Table 1: NEW ECONOMY CASE. CASH FLOWS AND TIMING |
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General speaking, WACC is the rate that a company’s shareholders expect to be paid on average to finance its assets, and it is the overall required return on the firm as a whole. Therefore, company directors often use WACC to determine whether a financial decision is feasible or not. In this case, I will choose 9.38% as discount rate. The reason why I choose 9.38% as discount rate is because the estimated Debt/Equity is 26% under the assumptions by CFO Sheila Dowling, which is most close to 25% of Debt/Equity from the projected WACC schedule. There might be some flaws existing by using WACC as discount rate. As we know, the cost of debt would be raised significantly as the leverage increased. The investment will definitely increase the firm’s current debt. So, the cost of debt would not keep at 7.75%.
What is the cost of equity capital appropriate for evaluating the free cash flow associated with this investment?
Keep using the old machine incurs higher cost(higher EAA) than replacing it with the new one. Therefore assuming sales are equal for both cases, when sales is smaller than 328338.07 and greater than 434036.67, Fonderia di Torino S.p.A should definitely replace the old machine with the new automated machine.
Our estimated cost of capital, 20.81%, is lower than Ricketts’ expected return, 30%-50%, thus the investment is worthy. However, it’s higher than other pessimistic members’ expected return, 10%-15%, making the decision more complex and requiring further valuation。
In November 2001, the costs of required rates of return on debt in the capital market are as follows:
Relationship between Age and Ship Price: From the regression, we find that as the ship ages by one year, the price of the ship drops by $ 4.54 mln. This makes sense because as with any other vehicle or asset, the efficiency of the ship drops with age. As it gets older, the carrying value of the ship lowers due to depreciation.
The mixture of debt-equity mix is important so as to maximize the stock price of the Costco. However, it will be significant to consider the Weighted Average Cost of Capital (WACC) as well so that it can evaluate the company targeted capital structure. Cost of capital (OC) may be used by the companies as for long term decision making, so industries that faced to take the important of Cost of capital seriously may not make the right choice by choosing the right project(Gitman’s, ).
a. What risk-free rate and risk premium did you use to calculate the cost of equity?
1. Two commonly used methods of financial analysis are payback and present value. Payback determines the length of time for an investment to return its original cost (1). Using the assumptions stated below the payback of the Jiminy Nick wind turbine with a cost of about $3.3 million would return the investment in about four years time. Net present value summarizes the initial cost of an investment, the estimated annual cash flows, and expected salvage value, taking into account the time value of money (1). A NPV calculation for the scenario SED is reviewing equals $7,697,286 minus the investment costs of $3,318,000 totaling $4,379,286.
Natalie estimates that all of her baking equipment will have a useful life of 5 years or 60 months and no salvage value. (Assume Natalie decides to record a full month’s worth of depreciation, regardless of when the equipment was obtained by the business.)
Estimated machinery life: 3 years (after which there will be zero value for the equipment and no further cost savings)
* We assume the cost of capital to be a stated annual rate to facilitate calculations;
The spreadsheet shows that the new ship would be best utilized on the Tallinn-Helsinki run, where it replace the capacity of three older ships, the Regina Baltica, the Fantaasia and the Vana-Tallinn. The spreadsheet does not factor in the fixed costs associated with each boat, but it is a reasonable assumption that the fixed costs of the three boats that would be sold are going to be higher than the fixed costs associated with the one new boat. It is recommended, therefore to purchase the new ferry as the solver illustrates that the new ferry would deliver greater contribution margin to Tallink than the three older ferries that it would replace.
Assume the ROE and payout ratio stay the same for the next 4 years. After that competition forces ROE down to 11.5% and the payout increases to 0.8. The cost of capital is 11.5%. (15 points)
* We assume a risk-free rate of 5.09%. This number comes from the current yield of the 30 year T-bond as shown in Exhibit 5.