FIN 310-The Galactic Empire (a tax-free entity) is designing

Subject: Business / Finance
Question
Question 2

The Galactic Empire (a tax-free entity) is designing a mega-project with extraordinary economic potential. The “Star” project is expected to cost $102.7 billion over 5 years of construction (schedule of costs below, all occur at the end of each year) but it will provide a net reduction in operating expenses by $16.4 billion annually on a permanent basis (forever) starting at the end of year 5. The appropriate cost of capital for this project is just 4.3%.

YEAR

Now

1

2

3

4

CAPEX

$35.2 billion

$21.8 billion

$18.3 billion

$13.1 billion

$14.3 billion

What is the project’s NPV?
Some designers believe that the project could begin to provide benefits as early as the end of year 3. They would need to increase expenses in the first 3 years (time 0-2) by $3 billion annually and try some experimental technology but there is an 85% these investments would result in savings of $10 and 14 billion at the end of years 3 and 4 respectively. This new design would have a slightly higher operating cost however (whether it starts up early or not), reducing subsequent savings (year 6 onwards) to $16.3 billion annually.

Should the experimental design be incorporated in the project?
At the meeting, one engineer points out that the new design introduces a critical weakness which could be sabotaged by “troublemakers”, resulting in the immediate loss of all project assets. Although the probability of being able to exploit this vulnerability is very low (0.0000001% chance, once, at the end of year 2 after capex is spent), the engineer would like permission to spend an additional $450 installing a piece of sheet metal he says would negate this scenario entirely.

What is the NPV of this engineer’s suggestion?
Question 6

Roman Roads has a number of capital projects available for investment this year but has access to a limited amount of capital. Specifically, the firm has arranged to secure a $25 million bond sale with their investment bankers and to sell new shares as well (no internally generated equity available for re-investment). They would like your advice on which projects they should pursue (all asset pools are quite large and would remain open after the projects are completed). According to the firm’s chief financial officer, Roman Roads has established its capital structure (target D/E ratio of 0.8) in line with the static trade-off theory so it should not be changed. The $25 million in new bonds will be sold off with a 7.4% annual coupon rate for total floatation costs of 2.7% (Roman Roads is not very well known). The firm’s common stock trades on the TSX Venture Exchange for $14.60 per share but it pays no dividends. Floatation costs on new equity have been estimated at 9% of the total proceeds of the sale. Independent analysts have estimated that the company has a beta of 2.2 with the broader market, which is expected to return 10% over the long run. Your best estimate for the average risk-free rate for the life of the projects 3.5%. Roman Roads pays an average tax rate of 25%.

Project 1 – $32 million upfront, $7.3 million after-tax profits annually for 8 years, salvage for $4.2 million, CCA rate = 20%

Project 2 – $22 million upfront, $5.8 million after-tax profits annually for 5 years, then $3.4 million after-tax profits for 4 more years, salvage assets for $6 million, CCA rate = 8%

Project 3 – $44 million upfront cost, $10 million in yearly after-tax profits for 20 years, no salvage, $20 million maintenance expense every 5 years (not paid at the end of the project’s life), CCA rate = 10%

Project 4 – $20 million upfront, $7.1 million after-tax profits annually for 3 years, salvage for $6.8 million, CCA rate = 20%

Project 5 – $29 million upfront cost, $8.4 million in yearly after-tax profits for 6 years, salvage for $12 million, requires $4 million in working capital (only half is recovered at project’s end), CCA rate = 15%

How much money will Roman Roads actually get from selling $25 million worth of bonds to investors?
If the capital structure is fixed, how much is Roman Roads’ capital budget for the year?
What cost of capital should be applied to these projects?
Which of the 5 projects above should be pursued given the firm’s budget restriction?
Question 7

Your firm is considering a project to supply 80 million postage stamps per year to Canada Post for the next five years. Production would take place on an idle piece of land that you could sell today for $1,200,000 and you would need to install $3,100,000 worth of equipment on site (20% CCA rate). The estimated salvage value of the equipment is $900,000 (asset pool would remain open). You would also require $600,000 in initial working capital, and an additional $50,000 per year thereafter, all of which is recovered as the project ends. Variable production costs are $7.50 per 1000 stamps and fixed costs are $800,000 per year.

If the firm’s tax rate is 34% and the required rate of return for this project is 15%, what is the minimum price you should charge Canada Post each year? (charge the same price every year)
If Canada Post is satisfied with your firm’s performance during the first 5 years (the above project), they would like the option to extend the contract for another 3 years. For these years, no additional working capital investment would be required and the full amount would be recoverable at the end of year 8 instead of year 5. Furthermore, the same machinery could be used to continue production though its salvage value would fall to $300,000 by the end of year 8. Assuming you charge Canada Post $3,000,000 per year for these 3 years and have the same cost structure as above, what is the incremental NPV of this extension?

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