Financial Management 401

Capital Budgeting Techniques

Company Information

Wheel Industries is considering a three-year expansion project, Project A. The project requires an initial investment of $1.5 million. The project will use the straight-line depreciation method. The project has no salvage value. It is estimated that the project will generate additional revenues of $1.2 million per year before tax and has additional annual costs of $600,000. The Marginal Tax rate is 35%. By calculating cash flow at 6% the net present value will be.

Depreciation = Cost of the asset – salvage value

Life of the asset

= 1,500,000/ 3

= 500,000

Calculation of cash flows:

Revenue – 1,200,000

Less Cost – 600,000

Less Depreciation – 500,000

Profit - 100,000

Less taxes (35%) 35,000

Profit after taxes 65,000

Add depreciation 500,000

Cash flow after taxes 565,000

NPV = Present value of cash flows - Cash outlay

= 565,000 x PVIFA 6%, 3 years – 1,200,000

= 565,000 x 2.6730 – 1,200,000

= 1,510,245 – 1,200,000

= 310,245

As the NPV is positive the project should be accepted.

Issue A

Wheel has just paid a dividend of $2.50 per share. The dividends are expected to grow at a constant rate of six percent per year forever. If the stock is currently selling for $50 per share with a 10% flotation cost, what is the cost of new equity for the firm? What are the advantages and disadvantages of using this type of financing for the firm?

Cost of equity Capital = D1 + g

P0

D1 = D0 (1 + g)

= 2.50 (1 + 0.06)

= 2.65

Cost of equity capital = 2.65 + 0.06

45

= 5.9 + 0.06

……………………...= 11.9

Advantages of Equity Financing

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