Question 1: Home Inc. is considering buying a new piece of equipment, which will cost $715,000 and has an economic life of 5 years, in order to produce a new line of product. The company believes they can sell 25,000 units of this new product per year at $130 per unit in each of next 5 years. The unit variable cost is $110 and total fixed costs (excluding CCA) are $195,000 per year.
The CCA rate for the new equipment is 30% and Home Inc. is going to claim the maximum CCA in each of the next 5 years.
Home Inc. needs to invest $140,000 in net working capital up front which will be fully recovered at the end of 5 years.
The equipment is estimated to be sold at its UCC value at the end of 5 years.
The discount rate is 15% and the tax rate is 35%.
Requirements: Show your calculation
a) Calculate the CCA allowance and ending UCC in each of the 5 years.
b) Calculate the net income and operating cash flow of this new product for each of the 5 years.
c) Calculate the initial investment outlay.
d) Calculate the PV of tax shield on CCA.
e) Determine whether Home Inc. should invest in the new equipment using NPV as the evaluation method.
Question 2: Flying High Inc. plans to raise $5,000,000 external financing through issuing bonds, and is considering two options: regular bonds and zero couple bonds. The regular bonds will have coupon rate at 10%, payable semi-annually, with face value of $1,000 each and maturity of 5 years. The zero coupon bonds will be the same as the regular bonds except that there is no coupon attached to these bonds, i.e. no interest payment throughout the life of the zero coupon bond.
Current market interest rate for 5-year bond of similar bond issuers like Flying High Inc. is 8%. Assume there is no issuance cost.
Requirements: Show your calculation
a) Calculate the price of regular bonds at the time of issuance.
b) Based on $1,000 face value for each bond, what is the minimum number of regular bonds to be issued to raise the required external financing of $5,000,000?
c) Calculate the price of zero coupon bonds at the time of issuance.
d) Based on $1,000 face value for each bond, what is the minimum number of zero coupon bonds to be issued to raise the required external financing of $5,000,000?
e) Assuming market interest rate remains unchanged in next 2 years, calculate the bond price at that time and explain the changes in price for each of these bonds.
f) Calculate the percentage of price change of each of the bonds between the time of issuance and 2 years after such time, and discuss why each of these bond prices changes.
Question 3: The capital structure of Wild West Inc. is as follows:
- Debts: $5,000,000 (face value) bonds with coupon rate at 8.00% and current price at par
- Preferred shares: $2,000,000 (face value) paying 5% dividends which is trading at 95 percent
- Common shares: Current stock price at $5 per share with 1,000,000 shares issued and outstanding. The risk-free rate is 5%, the market risk premium is 6%, and the beta of Wild West Inc. is 1.15
- Marginal tax rate is 40%
Requirements: Show your calculation
a) Calculate the WACC for Wild West Inc.
b) Should Wild West Inc. accept an IRR of 7% new project which is of similar risk as all the existing projects of the Big Plan? Why and why not?
c) Should Wild West Inc. accept an IRR of 12% new project which is considered 30% higher in risk as compared with all the existing projects of the Big Plan? Why and why not?
Question 4: The credit term from the supplier is 2/30, net 60.
Requirements: Show the calculation
Calculate the effective annual rate if the firm does not take the discount.
Question 5: Great Pumpkin Farms just paid a dividend of $3.50 on its stock. The growth rate in dividends is expected to be a constant 5 percent per year indefinitely. Investors require a 16 percent return on the stock for the first 3 years, a 14 percent return for the next 3 years, and 11 percent return thereafter.
Requirements: Show your calculation
Calculate the current stock price of Great Pumpkins Farms.
Question 6: In the NPV analysis, sunk cost is not relevant whereas opportunity cost is for project evaluation.
Requirements:
Explain and justify the above statement about sunk cost and opportunity cost.