Answered: Calculate the appropriate discount rate…

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter10: Capital Budgeting: Decision Criteria And Real Option

Section: Chapter Questions

Problem 4P

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Question

Rare Agri-Products Ltd. is currently evaluating a potential new project that is expected to have a duration of seven (7) years. This project falls under the government's subsidy program aimed at promoting local agricultural products, making it eligible for a one-time rebate of 25% on the initial equipment investment. The cost of the initial equipment (IE) is estimated to be $41,000,000. Additionally, at the end of year 3, an additional equipment (AE) costing $3,500,000 will be required. It is worth noting that at the end of the seven (7) years, the original equipment (IE) will have no resale value, while the supplementary equipment (AE) can be sold for $50,000. Furthermore, a working capital of $1,350,000 will be necessary for the project.

Sales projections for agri-products over the seven-year period are as follows:

Year 1: 70,000 units
Year 2: 100,000 units
Years 3-5: 250,000 units
Years 6-7: 325,000 units
The expected selling price per unit is $150 for the first two years, which will then decrease to $90 per unit due to the diminishing novelty of the product. Variable expenses are anticipated to amount to 30% of the sales revenue, while fixed cash operating expenses will be $1,100,000 per year.

Rare Agri-Products Ltd. falls into the 25% tax category for ordinary income and the 40% tax category for capital gains.

Depreciation for the initial equipment will be calculated based on the 7-year MACRS system, whereas the additional equipment will be depreciated using the straight-line method. In the event of a negative taxable income, the tax will be computed as usual and reported as a negative figure, indicating a reduction in post-tax losses.

The initial financing of the project will consist of 55% equity and 45% debt. The company paid a dividend of $1.50 per share this year, and it is expected to increase at a rate of 3% per year in the near future. The current price per share of the company's stock is $9.50. The bank loan is likely to be arranged at an interest rate of 13.5% per annum.

You are tasked with the following:

Calculate the appropriate discount rate for discounting the project's cash flows.
Determine the initial investment required.
Compute the earnings before taxes for each of the seven years.
Calculate the earnings after taxes for each of the seven years.
Determine the operating cash flow (OCF) for each of the seven years.
Compute the terminal cash flow.
Calculate the free cash flow (FCF) for each of the seven years.
Determine the net present value (NPV) and internal rate of return (IRR).
Based on the calculations, provide a recommendation on whether the project should be accepted or not.

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