Peterson plc is considering opening a medical laboratory in Preston. The project requires an initial investment of
Question:
Peterson plc is considering opening a medical laboratory in Preston. The project requires an initial investment of £500,000 in equipment. For this project, Peterson is also planning to use a building purchased 5 years ago for £150,000. The current value of the building is £180,000 and £40,000 is required to be invested for renovation before the project starts. Cash flows from sales and cash costs all occur at a frequency of 12 months indefinitely. The first sales and cost cash flows occur one year after the implementation of the project and the variable cost of the project amounts to 40% of sales. The firm is subject to 20% tax rate and the firm's all-equity cost of capital is 10% per annum. The firm's cost of debt is 6% per annum and, for simplicity, it can be assumed that the corporate debt of this firm is risk-free. The initial cash outflow of the project does not trigger any depreciation.
Assume that this is the only project of the firm. If the project is financed with 100% equity its net present value is zero.
REQUIRED
i) What is the level of sales that the project generates each year? (6 marks)
ii) Assume that 50% of the initial cash outflow is financed with debt. Calculate the adjusted present-value. Should the firm implement the project under the new assumption? (5 marks)
iii) Assume that, as in (ii), 50% of the initial cash outflow is financed with debt. Use the flowto-equity approach to calculate the net present value of the project. Should the firm implement the project? (8 marks)
iv) Assume that, as in (ii) and (iii), 50% of the initial cash outflow is financed with debt. Use the weighted-average-cost-of-capital approach to calculate the net present value of the project. Should the firm implement the project? (6 marks) v) "The shareholders of a levered firm will never want the firm to invest in a negative net present value project." Do you agree or disagree with this statement? Explain.
Fundamentals of Corporate Finance
ISBN: 978-1259024962
6th Canadian edition
Authors: Richard Brealey, Stewart Myers, Alan Marcus, Devashis Mitra, Elizabeth Maynes, William Lim