A large investment company is analyzing the profitability of a farming investment for one of its corporate clients. The investment requires a $10 million outlay to acquire the necessary assets and is projected to yield an annual payment flow of $2 million (before interest payments) over a 20-year horizon.
The analysts figure a 12 percent cost of equity capital, a 10 percent cost of debt capital, a 20 percent salvage value (of the initial outlay), financing by a bond sale at 10 percent with principal due at the end of the twentieth year, and constant financial leverage as indicated by the corporation’s equity-to-asset ratio of 0.5. Disregard income taxes.
a) What method of investment analysis would you use to evaluate this investment? Why?
b) Show clearly how you would set up the investment analysis model, and show its solution.
c) Explain your procedures for handling the investment’s financing plan.