Step-by-step Solution Required:
1. Frieda Inc. is considering a capital expansion project. The initial investment of undertaking this project is $105,500. This expansion project will last for five years. The net operating cash flows from the expansion project at the end of year 1, 2, 3, 4 and 5 are estimated to be $22,500, $ 25,800, $ 33,000, $45,936 and $58,500 respectively.
Frieda has a capital structure consisting of 20% debt and 80% equity. The after-tax cost of debt is 20% and the cost of equity is 25%.
What is Frieda’s weighted average cost of capital?
2. Continued from Question 1, based on Frieda’s weighted average cost of capital calculated, what is the NPV of undertaking this expansion project? That is, what is the NPV if the weighted average cost of capital is used as the discount rate?
3. Based on the NPV obtained in Question 2, shall Frieda undertake the expansion project?
4. Continued from Question 1, based on Frieda’s weighted average cost of capital calculated, what is the profitability index of undertaking this project? That is, what is the profitability index if the weighted average cost of capital is used as the discount rate?
5. Based on the Profitability Index (PI) obtained in Question 4, shall Frieda undertake the expansion project?
6. Continued from Question 1, what is the internal rate of return (IRR) if Frieda undertakes this project?
7. Based on IRR obtained in Question 6, shall Frieda undertake this project? Assuming the weighted average cost of capital (calculated in Question 1) is the appropriate discount rate for the capital budgeting problems considered.
8. Continued from Question 1, what is the modified internal rate of return if Frieda undertakes this project. Assuming that the positive cash inflow from undertaking this project will be reinvested at the weighted average cost of capital calculated in Question 1.
9. Commercial Hydronics Incorporation is considering an asset replacement project of replacing a control device. This old control device has been fully depreciated but can be sold for $5,000. The new control device, which is more automated, will cost $22,000. The new device’s installation and shipping costs will total $12,000. The new device will be depreciated on a straight-line basis over its 2-year economic life to an estimated salvage value of $0. The actual salvage value of this device at the end of 2-year period (That is, the market value of the device at the end of 2-year period) is estimated to be $3,000. If the replacement project is accepted, Commercial Hydronics will require an initial working capital investment of $3,000 (that is, adding $3,000 initially to its net working capital).
During the 1st year of operations, Commercial Hydronics expects its annual revenue to increase from $65,000 to $85,000. After the 1st year, revenues from the replacement are expected to increase at a rate of $2,200 a year for the remainder of the project life.
Commercial Hydronics' incremental operating costs associated with the replacement project are expected to decrease from $20,000 to $12,000 during the 1st year and increase at a rate of $2500 for the remainder of the project life.
Commercial Hydronics expects that it will have to add about $2,000 to its net working capital in year 1, and nothing in year 2. At the end of the project, the total accumulated net working capital required by the project will be recovered.
Commercial Hydronics has a marginal tax rate of 35%. What is the initial net investment for Commercial Hydronics to undertake this replacement project?
10. Continued from Question 9, what is the net operating cash flow at the end of year 1?
11. Continued from Question 9, what is the net operating cash flow at the end of year 2?
12. Dunkin currently has a capital structure of 60 percent debt and 40 percent equity, but is considering a new product that will be produced and marketed by a separate division. The new division will have a capital structure of 80 percent debt and 20 percent equity. Dunkin has a current beta of 2.1, but is not sure what the beta for the new division will be. AMX is a firm that produces a product similar to the product under consideration by Dunkin. AMX has a beta of 1.8, a capital structure of 35 percent debt, and 65 percent equity and a marginal tax rate of 40 percent. Dunkin tax rate is 40 percent. What will be Dunkin’s weighted cost of capital for this new division if the after-tax cost of debt is 8percent, the risk-free rate is 7 percent, and the market risk premium is 9 percent?