You are the CEO of Namrog Corporation. You are interested in evaluating the following project proposal. The project will span 7 years.
Namrog is a precision machine parts manufacturer, which serves the aerospace industry. Namrog is profitable, and is expected to remain so. Namrog is considering the purchase of an automated welding machine which will increase both revenues and expenses.
Initially, you will purchase the welding machine for €57,000 (turn key installed). The machine will be depreciated over 4 years using straight line depreciation to a value of zero. The machine will be sold for €15,500 after 7 years.
Revenues in the first three years are expected to be €34,000/year, and are expected to be €40,000 in the subsequent 4 years. Operating expenses are expected to be 40% of revenue in all seven years.
The machine will require an immediate increase in inventory from zero to €1200, and the inventory level will grow thereafter at €40 per year. After 7 years the inventory level will immediately return to zero.
Accounts payable will require an immediate increase from zero to €1000, and this level will grow thereafter at €50 per year. After 7 years the A/P level will immediately return to zero.
Accounts receivable will require an increase in one year (not immediately) from zero to €900, and this level will grow thereafter by €60 per year. After 7 years the A/R level will immediately return to zero.
At the moment, the beta of Namrog stock is 0.70, and Namrog bonds have a yield to maturity (YTM) of 7.0%. The firm is currently financed 30% with equity and 70% with bonds. These weights are based on the market values of debt and equity.
The expected return on the market is 10.3%, and the risk free rate is 4%. Inflation is expected to be 2.6%. It's raining in Baltimore. Former President George W. Bush is still incompetent. Assume the CAPM is the appropriate model linking risk with expected return.
Namrog will borrow money to purchase the machine. The machine's purchase is being financed by a 5 year bank loan, using an interest rate of 10% per year with payments once a year. The loan is structured so that only interest of €5,700 ( = 10% of the €57,000 loan) is paid in years 1 through 5, and in the 5th year the entire €57,000 is paid back as well.
The marginal tax rate is 34% per year.
Show in detail the computations associataed with the above problem.
You can either type or hand write the computations above. If you choose to write the equations out by hand, then please scan this as a .pdf file, and supply it along with the Word-2003 format .doc file that is also required. The handwritten calculations are the only part of this assignment that can be in a .pdf format.
Please discuss the following: Support your comments with computations from this specific problem whenever possible.
1. Compute all cash flows, discount rates and determine if the project should be undertaken.
2. Show both the equations and the variables, and show the equations with the variables inserted into the equations.
3. How does depreciation affect cash flow, and what is the magnitude of the cash flow impact of depreciation in each year?
4. Discuss the concept of tax shields. How do they affect valuation?
5. How did you obtain the discount rate, and why it is the appropriate rate for valuing the project?
6. How did you obtain the cash flows, what do they measure, and why are they appropriate for this problem.? (show the cash flow computations in each year).
7. How would you determine if the project should be undertaken by using the NPV rule?
8. How would you determine if the project should be undertaken by using the IRR rule?
9. Discuss the link between the IRR you computed and the NPV you computed for this problem (i.e. focus on the cash flows associated with this specific problem).
10. How did you handle inflation, and what effect did it have on your cash flows, discounnt rate, and overall assesment regarding whether or not the project should be undertaken?