HBH Enterprises is a large publicly listed company

HBH Enterprises is a large publicly listed company, specialised in manufacturing washing machines.  The company is looking to set up a manufacturing plant to produce a new line of washing machines. This project will be a six-year project. The company bought a piece of land four years ago for $ 10 million in anticipation of using it for its proposed manufacturing plant. If the company sold the land today, it would receive $ 11.5 million after taxes. In six years, the land can be sold for $8 million after taxes and reclamation costs. HBH Enterprises wants to build a new manufacturing plant on this land. The plant will cost $350 million to build. The following market data on HBH’s securities are current:

Debt

$250,000,000, 6.75% coupon bonds outstanding with 20 years to maturity redeemable at par, selling for 92 percent of par; the bonds have a $1000 par value each and make semi-annual coupon payments.

Equity

40,000,000ordinary shares, selling for $42.50 per share

Non-redeemable Preference shares

15,000,000 shares (par value $ 12 per share) with 5.5% dividends (after taxes), selling for $24 per share

The following information is relevant:

· HBH Enterprises’  tax rate is 28%

The company had been paying dividends on its ordinary shares consistently. Dividends paid during the past five years is as follows

Year (-4) ($) 2.25

Year (-3) ($) 2.35

Year (-2) ($) 2.81

Year (-1) ($) 2.95

Year (0) ($) 3.20

The project requires $ 11 million in initial net working capital investment in year 0 to become operational.
Work all solutions to the nearest two decimals.

Required:

Calculate the project’s initial, (time 0) cash flows, taking into account all side effects.

(2 marks)

Compute the weighted average cost of capital (WACC) of HBH Enterprises. Show all workings and state the assumptions underlying your computations.

(12 marks)

Using the WACC computed in part (2) above and assuming the following, compute the project’s Net Present Value (NPV), Internal Rate of Return (IRR) and the Profitability Index (PI)
The manufacturing plant has a ten-year tax life, and HBH Enterprises uses Diminishing value method depreciation for the plant at 20% per annum. At the end of the project, (i.e., at the end of year 6), the plant can be scrapped for $ 71 million.
The project will incur $310 million per annum in fixed costs
HBH Enterprises will manufacture 420,000 washing machines per year and expects to sell them at an average price of $ 2,500 per washing machine.
The variable production costs are $ 1,400 per washing machine.
At the end of year 6, the company will sell the land.

(16 marks)

2.2. What are the pros and cons of using risk-adjusted costs of capital for individual investments?

Here’s the SOLUTION

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