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Year After-Tax Cash Flow

RWE Enterprises is considering purchasing a new production line that would increase their production capacity by 120%. The new line would cost $3 million to purchase and install, with an estimated scrap value after 10 years of $200,000. It would also require $2 million in refurbishment after 5 years. Management estimates the line would generate $700,000 in after-tax cash flow annually for 10 years. Calculating the NPV at a 10% discount rate shows a positive value, indicating the project may create value for RWE. The IRR of 18% and PI of 1.18 also suggest the project is viable. The payback period is just under 7 years and the discounted payback is around 8

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Zehra Khan
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94 views

Year After-Tax Cash Flow

RWE Enterprises is considering purchasing a new production line that would increase their production capacity by 120%. The new line would cost $3 million to purchase and install, with an estimated scrap value after 10 years of $200,000. It would also require $2 million in refurbishment after 5 years. Management estimates the line would generate $700,000 in after-tax cash flow annually for 10 years. Calculating the NPV at a 10% discount rate shows a positive value, indicating the project may create value for RWE. The IRR of 18% and PI of 1.18 also suggest the project is viable. The payback period is just under 7 years and the discounted payback is around 8

Uploaded by

Zehra Khan
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Question 1

RWE Enterprises: Expansion project analysis RWE Enterprises Pty Ltd is a small manufacturing firm located in
Brisbane. The firm is engaged in the manufacture and sale of feed supplements used by cattle raisers. The product
has a molasses base but is supplemented with minerals and vitamins that are generally thought to be essential to
the health and growth of beef cattle. The final product is put in 75-kg or 100-kg tubs that are then made available
for the cattle to lick as desired. The material in the tub becomes very hard, which limits the animals’ consumption.

The firm has been running a single production fine for the past five years and is considering the addition of a new
fine. The addition would expand the firm’s capacity by almost 120% because the newer equipment requires a
shorter downtime between batches. After each production run, the boiler used to prepare the molasses for the
addition of minerals and vitamins must be heated to 85 degrees Celsius and then must be cooled before beginning
the next batch. The total production ran entails about four hours and the cool-down period is two hours (during
which time the whole process comes to a halt). Using two production fines increases the overall efficiency of the
operation because workers from the fine that is cooling can be moved to the other fine to support the ‘canning’
process involved in filling the feed tubs.

The equipment for the second production fine will cost $3 million to purchase and install and will have an
estimated fife of 10 years, at which time it can be sold for an estimated after-tax scrap value of $200000.
Furthermore, at the end of five years, the production fine will have to be refurbished at an estimated cost of $2
million. RWE’s management estimates that the new production fine will add $700000 per year in after-tax cash
flow to the firm, such that the full 10-year cash flows for the fine are as follows:
Year After-tax cash flow

0 $(3000000)

1 700000

2 700000

3 700000

4 700000

5 (1300000)

6 700000

7 700000

8 700000

9 700000

10 900000

Jamie Dermott: Mutually exclusive project analysis

Jamie Dermott graduated from RMIT University in

December and has been working for about a month as a junior financial analyst at Caledonia Products. When Jamie
arrived at work on Friday morning, he found the following memo in his email inbox:

TO: Jamie Dermott

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FROM: V. Morrison, CFO, Caledonia Products

RE: Capital budgeting analysis Provide an evaluation of two proposed projects with the following cash flow
forecasts:

Questions

1. If RWE uses a 10% discount rate to evaluate investments of this type, what is the net present value of the
project? What does this NPV indicate about the potential value RWE might create by purchasing the new
production line?

2. Calculate the internal rate of return and profitability index for the proposed investment. What do these two
measures tell you about the project’s viability?

3. Calculate the payback and discounted payback for the proposed investment. Interpret your findings.

Question 2

The Nealon Manufacturing Company is in the midst of negotiations to acquire a plant in Broken Hill, NSW. The
company CFO, James Nealon, is the son of the founder and CEO of the company and heir-apparent to the CEO
position, so he is very concerned about making such a large commitment of money to the new plant. The cost of
the purchase is $40 million, which is roughly half the size of the company today.

To begin his analysis, James has launched the firm’s first-ever cost-of-capital estimation. The company’s current balance
sheet, restated to reflect market values, has been converted to percentages as shown in the table below.

The company paid dividends to its ordinary shareholders of $2.50 per share last year, and the projected rate of annual
growth in dividends is 6% per year for the indefinite future.

Nealon’s ordinary shares trade over the counter and have a current market price of $35 per share. In addition, the
firm’s bonds have an AA rating. Moreover, AA bonds are currently yielding 7%. The preference shares have a current
market price of $19.

Questions
1. If the firm’s tax rate is 30%, what is the weighted average cost of capital (i.e. what is the firm’s WACC)?

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2. In the analysis done so far we have not considered the effects of flotation costs. Assume now that Nealon is raising a
total of $40 million using the above financing mix. New debt financing will require that the firm pay 50 basis points (i.e.
0.5%) in issue costs, the sale of preference shares will require the firm to pay 200 basis points in flotation costs and the
ordinary shares issue will require flotation costs of 500 basis points.
(a) What are the total flotation costs the firm will incur to raise the needed $40 million?
(b) How should the flotation costs be incorporated into the analysis of the $40 million investment the firm plans to
make?

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