The Horace Newtech Company is considering the introduction of a
new product. Generally, the company's products have a life of about
5 years, after which they are deleted from the range of products
that the company sells. The new product requires the purchase of
new equipment costing $9,500,000, including freight and
installation charges. The useful life of the equipment is 5 years,
with an estimated resale of equipment of $2,750,000 at the end of
that period. The equipment will be fully depreciated to zero value
using the straight line (prime cost) method. The new product will
be manufactured in a factory already owned by the company. This
factory is currently being rented to another company under a lease
agreement that has 5 years to run and provides for an annual rental
of $190,000. Under the lease agreement, the Horace Newtech Company
can cancel the lease by immediately (year 0) paying the lessee
compensation equal to 1 year's rental payment. It is expected that
the product will involve the company in market research
expenditures that will amount to $750,000 during the first year the
product is on the market. Additions to current assets (net working
capital) will require $310,000 at the commencement of the project
and are assumed to be fully recoverable at the end of the fifth
year. The new product is expected to generate sales revenue as
follows: Year 1: $3,250,000 Year 2: $3,750,000 Year 3: $3,500,000
Year 4: $3,250,000 Year 5: $1,750,000 It is assumed that all cash
flows are received at the end of each year. The corporate tax rate
is 25%. Horace Newtech Company has an equity beta of 0.5. Its
capital structure consists of equal amounts of equity and debt. The
risk free rate is 5%. The debt has a pre-tax yield of 9% and the
expected rate of return on the market index is 18%. Using the
inputs suggested in the proposed investment, design an Excel
financial model that can help to evaluate the project.
a. What is Horace Newtech Company ’s weighted average cost of capital (WACC)?
b. Estimate the free cash flows of the project.
c. What is the net present value (NPV) and internal rate of return (IRR) of the project? Should Horace Newtech Company undertake the project based on NPV? How about IRR? Do both NPV and IRR lead to the same decision?
d. Draw a line graph to illustrate the sensitivity of the NPV to changes in WACC? The graph should have a chart title, as well as x- and y-axis labels. Briefly explain the relationship between WACC and NPV.
a. What is Horace Newtech Company ’s weighted average cost of capital (WACC)?
b. Estimate the free cash flows of the project.
c. What is the net present value (NPV) and internal rate of return (IRR) of the project? Should Horace Newtech Company undertake the project based on NPV? How about IRR? Do both NPV and IRR lead to the same decision?
d. Draw a line graph to illustrate the sensitivity of the NPV to changes in WACC? The graph should have a chart title, as well as x- and y-axis labels. Briefly explain the relationship between WACC and NPV.
