Case scenario:
Arduo Associates, a financial and accounting consulting firm, received a request from a major client. The client is considering 2 new projects. You, a junior financial analyst, are assigned to prepare a quantitative analysis based on the information provided by the client. To save your analysis, you needn't consider change in work capital, depreciation, and salvage value.
Note the return on asset given is rate of return on assets all financed by equity capital, in other words, the ROA of an all-equity company.
Project A:
Cash flows are perpetual. Debt is also perpetual.
Annual revenue = $250,000.00
Costs = 60% of sales
Initial investments = $425,000.00
tax rate 20%
return on asset = 20%
Firm is considering 3 scenarios: all equity, $150,000 of debt, and $200,000 of debt, at 10% cost of debt.
Analyze these 3 scenarios.
Project B:
Project life = 4 years
Annual sales revenue = $250,000.00
Costs = 40% of sales
Initial investments = $275,000.00
tax rate = 20%
return on asset = 20%
Firm is considering 3 scenarios: all equity, $150,000 of debt, and $200,000 of debt, at 10% cost of debt.
Analyze these 3 scenarios.
Which project and what level of debt would you recommend? Justify your decision.