Corporation recently gained a contract for the next 5 years and considers three alternatives to exploit the
Question:
Corporation recently gained a contract for the next 5 years and considers three alternatives to exploit the contract:
A. Buy a relatively old ship with large car garages that has been running these routes for several years and will continue to do so for another 5 years without major
refurbishment. The cost of the ship is €13m and is expected to leave a scrap value of 1m, 5 years from now. The CFO estimates a revenue of €10.8m with total costs
of €6.5m every year. To set the working capital, an initial amount of 1m is deemed as necessary, with another €100,000 to be added to it every year. At the end of the
5-year contract, the working capital is to be recovered by the company.
B. Buy the same liner as A and proceed to a major refurbishment and engine upgrade, before the start of the first season, that will allow better passenger accommodation
and faster travel times. The refurbishment/ upgrade will cost another €3.5m and the ship is expected to leave the same residual scrap of 1m after 5 years. However, in
this case, the CFO estimates a higher revenue of €12m with projected total costs of €6.4m every year. To set the working capital, an initial amount of 1m is again
deemed as necessary from year 1, with another €120,000 to be added to it every year. At the end of the 5-year contract, the working capital is to be recovered by the
company.
C. Buy a much newer vessel with very fast travel times but with limited capacity for passengers and cars. This ship will be able to make twice as many voyages as the
ship in alternatives A and B. The cost of this ship is €22m and is expected to leave a residual value of €8m after 5 years. According to this scenario, the CFO estimates
a revenue of €15m with projected total costs of €8.9m every year. To set the working capital, an initial amount of €2m is deemed as necessary, with another
€200,000 to be added to it every year. At the end of the 5-year contract, the working capital is to be recovered by the company.
Before gaining the contract XYZ paid for research using multiple surveys among passengers to get a better grasp about their preferences and how they make their
travelling decisions. The cost of this research was €100,000. To finance the project the CFO will issue €14m worth of preferred stock. The stock will pay an annual dividend
of €0.50 forever and will be offered to potential buyers at €5.0 each. Issuance and distribution fees paid to the primary market dealers are estimated at the 1.5% of the
offered price. To cover any additional need for funding, the firm will then issue a 5- year bond with annual coupons and 10% coupon rate. The bond will be issued at par,
but the primary market dealers will receive 1.5% fees for issuance and distribution costs. The tax rate of the company is 35% and fixed assets are fully depreciated for tax
purposes using the straight-line depreciation method.
Questions:
1. Calculate the Net Cashflows of each of the three projects.
2. Calculate the WACC for each of the three projects.
3. Calculate the NPV, IRR and Profitability Index of the three projects.
4. Which of the 3 projects should be rejected, and which one is the optimal alternative?
Foundations of Finance The Logic and Practice of Financial Management
ISBN: 978-0132994873
8th edition
Authors: Arthur J. Keown, John D. Martin, J. William Petty