You are considering an investment in nickel mines in Russia. Your expectations are that you will take losses eventually, but once infrastructure is built, the project will become more profitable very quickly. You have estimated that the initial revenues will be $100 million per year and grow at a rate of 45% per year for four years. Due to political risk, you decide to use only a four-year horizon for planning purposes. Variable costs are expected to be 70% of sales; fixed costs are projected to be $10 million per year. Initial cost of machinery, land, equipment and other things amounts to $110 million. This $110 million will be depreciated straight-line to zero over a seven-year accounting life. However, the expected market value of the fixed assets at the end of four years is $50 million. Net working capital requirements are minimal, just $10 million at the beginning of the project, all of which will be recovered at termination. Tax rate of your company is 30%. This project will be financed with both debt and equity. The plan is to mirror the firm’s target capital structure by issuing 15 million shares of stock priced at $10.00 a share and $170 million face value of 10-year bonds which will be priced at 94% of par if a coupon of 7% is offered to investors. The company will pay dividends of $3.60 per year (starting in one year) and increase the dividend by 4% per year indefinitely. Treasury bills offer 1% return and the expected market returns are 11% per year. The stock’s beta is 1.8. What are the cash flows each year from this project?

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter11: Capital Budgeting And Risk

Section: Chapter Questions

Problem 20P

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You are considering an investment in nickel mines in Russia. Your expectations are that you will take losses eventually, but once infrastructure is built, the project will become more profitable very quickly. You have estimated that the initial revenues will be $100 million per year and grow at a rate of 45% per year for four years. Due to political risk, you decide to use only a four-year horizon for planning purposes. Variable costs are expected to be 70% of sales; fixed costs are projected to be $10 million per year. Initial cost of machinery, land, equipment and other things amounts to $110 million. This $110 million will be depreciated straight-line to zero over a seven-year accounting life. However, the expected market value of the fixed assets at the end of four years is $50 million. Net working capital requirements are minimal, just $10 million at the beginning of the project, all of which will be recovered at termination. Tax rate of your company is 30%. This project will be financed with both debt and equity. The plan is to mirror the firm’s target capital structure by issuing 15 million shares of stock priced at $10.00 a share and $170 million face value of 10-year bonds which will be priced at 94% of par if a coupon of 7% is offered to investors. The company will pay dividends of $3.60 per year (starting in one year) and increase the dividend by 4% per year indefinitely. Treasury bills offer 1% return and the expected market returns are 11% per year. The stock’s beta is 1.8.

What are the cash flows each year from this project?

What is the WACC?

What is the total initial cost after adjusting for flotation costs?

What are the NPV, IRR, PI and simple (not discounted) payback period for the project?

WILL YOU ACCEPT THE PROJECT OR NOT? WHY (OR WHY NOT)?

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