As the project manager of Budget Pty Ltd, you are considering whether the company should invest in Project ‘Delta’.

Budget Pty Ltd has the following characteristics:

Preferred Shares
The market value of Budget Pty Ltd’s preference shares is $5,000,000 with a cost of preferred equity of 8% p.a. in nominal terms.

Common Shares
The price of common shares in currently trading at $40 per share.
Its beta is 1.2 and the expected market risk premium is 6% p.a. in nominal terms. The number of common shares outstanding is 300,000 shares.

Debentures
The current return on Budget Pty Ltd’s debentures is 1% p.a. above the nominal risk-free rate.
It has issued 100,000 debentures that have a par value of $100 paying an annual coupon at a rate of 10% p.a.
The debentures have just paid an interest payment and will mature in 5 years’ time

It is expected that project Delta will have the same risk and will use a financing mix similar to that of Budget Pty ltd. You have also collected the following information about Budget Pty Ltd:

Requires new equipment to be purchased immediately for the project to commence. The cost (in ‘000s) of this new equipment is $4,500. The equipment can be depreciated on a straight-line basis to $0 over the life of the project.
The interest payable perineum on their debentures is $1 million.

Project Delta is expected to generate the following sales each year: Year 1- 500 units
Year 2- 700 units
Year 3- 800 units

The forecasted sale price is $20 per unit in Year 1 and this is expected to increase in line with inflation.
The predicted cost of goods sold (COGS) is $15 per unit for year 1. Similarly, this is expected to increase in line with inflation

The expected inflation rate is 5% p.a.

Budget Pty Ltd is subject to a corporate tax rate of 30% p.a. and operated under a classical tax system. The current risk-free rate is 0.5% p.a. in real terms. Assume that all rates given are compounded annually.

(a). What are the nominal net cash flows (after-tax) for Project Delta in Years 0-3?

(b). What is the weighted average cost of capital of Budget Pty Ltd?

(c). What is the nominal NPV of Project Delta? Should you accept the project? Explain.

(d). Now your CFO says that the costs of Project Delta have to be paid back in one year’s time because your CFO is pessimistic about the future prospects of the economy. What is the discounted payback period of Project Delta? Should you accept the project, given your CFO’S criterion? Explain.

(e). Is your decision in part (d) wealth maximizing for your shareholders or not? Explain.

Answer rating: 100% (QA)

a Year 0 4500 Year 1 500 20 x 500 units 15 x 500 units x 1 03 Year 2 700 20 x 700 units 15 x 700 units x 1 03 Year 3 800 20 x 800 units ... View the full answer