Practice_Question_for_Final_solution

Practice_Question_for_Final_solution - Practice Question...

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Unformatted text preview: Practice Question for Final Suppose Alcoa is considering an investment that would extend the life of one of its aluminum mines for four years. The project would require upfront costs (operating expenses at year 0) of $6.67 million plus a $24 million investment in equipment. The equipment will be obsolete in four years and will be depreciated via straight‐line method over that period. During the next four years, Alcoa expects annual sales of $60 million per year from this mine. Mining costs and operating expenses are expected to total $25 million and $9 million, respectively, per year in the following four years. Finally Alcoa expects no net working capital requirements for the project, and it pays a corporate tax of 35%. a. What are the incremental earnings if Alcoa chooses to take the project? b. What are the incremental cash flows if Alcoa chooses to take the project? Depreciation=24/4=$6 million. Answer: c. To decide whether to take the project or not, Alcoa still need the information for cost of capital. Suppose currently there are two types of financing: long‐term bond and equity. The total market value of long‐term bond outstanding is $100 million, with a total face value of $100 million and coupon rate of 6%. There are 1 million shares outstanding for common stocks and each share are traded at $150. The beta for the stock is 1.5, the risk free rate is 4%, and the market risk premium is expected to be 8%. What is the WACC for the company? Answer: Since the bond face value is equal to the market value, the yield is the same as the coupon rate: rD = 6% . From CAPM, the expected stock return is: rE = rf + β (rm - rf ) = 4% + 1.5 × 8% = 16%. Note total market value of bond is $100 million, and market value of equity is $150*1 million= $150 million. So from WACC formula: WACC = D E 100 150 (1 − τ )rD + rE = × (1 − 0.35) × 6% + × 16% = 1.56% + 9.6% = 11.16% D+E D+E 250 250 d. Assume the project risk is the same as the company risk, so that you can use the company WACC as the project WACC. Based on part a, b, c, d, should Alcoa take the project or not? Why? Answer: NPV = −28.34 + 19 ⎛ 1⎞ ⎜1 − ⎟ = −28.34 + 58.75 = 30.41 > 0 0.1116 ⎝ 1.1116 4 ⎠ So you should take the project. ...
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