OASIS Cables Company is considering a new project of introducing a new type of “Twisted Shield Cables” to the market. In order to produce the cable, a machine must be purchased for O.R 2.5 million with 5 years of economic life. The marketing department of the company has already run a research on the potential customers to identify the prospect of this product. An independent consultant was also hired to identify the prospective sales. Total cost of running research and hiring consultant was O.R 500,000. According to their combined projections, in the first year the company will be able to sell 40,000 meters of the shield cable at a price of O.R 40 per meter. The selling price per meter is expected to remain the same during the 5-year life of the project. The production and sales of the product in years 2, 3, 4, and 5 will be 45,000; 48,000; 40,000; and 30,000 meters respectively. The machine will be fully depreciated over 5 years using straight-line method. Cost of goods sold per unit is expected to be O.R 15. After 5 years the machine can be sold for O.R 300,000.
To raise the required capital for taking this project, the company will use 40% debt (primarily bonds) and 60% common stock equity, which is also the optimum capital structure for the firm. The debt financing will be done through bonds. A similar kind of bond of the firm is currently selling in the market for O.R 950 with 6% coupon rate and O.R 1,000 face value. The maturity is in 10 years. The common stock of the firm is currently selling in the market for O.R 2.00 and has recently declared and paid dividend of O.R 0.100 per share. The dividend is expected to grow at an annual rate of 3% per year. The company is in 25% tax bracket.
Instructions:
* What is the gross profit margin per meter of the shield cable?
* Calculate the cash payback period of this investment.
* Determine the Weighted Average Cost of Capital (WACC).
* Assuming WACC is the discount rate, calculate the profitability index of the project and decide whether Oman Cables should accept the project.
* If OASIS Cables is willing to reduce its WACC by 1%, estimate the proportionate debt to equity financing.