Running Head: ABCS COMPANY

ABCs company
Students Name
Institution affiliated
Professors Name
Date

ABCS COMPANY

ABCS COMPANY
Instructions:

Attempt the following problems to help Singleton make the decisions. All cash flows and present
values must be rounded to the nearest thousand dollars. Show all workings and/or explanation.
Answers:
1. Calculate ABCs company after-tax WACC, rounded to four decimal places
WACC= WACC= ke*we+ kd*wd+kp*wd
Cost of equity = risk- free rate +beta (risk premium) = 2.5+1.29(7) = 11.53%
Cost of preferred shares= Dividends/ market price- floatation costs
Cost of preferred shares = 10/95= 10.5263%
Cost of debts = (9.5%*570+9%*575+8.5%*10)/(570 +575+10)*0.7=9.23% (0.70) = 6.47.%
Weight of debt= debt/total capital, total capital = 10+575+570+580+20= 1755
Weight of debt= 1155/1755= 0.65811,
Weight of preferred equity = 20/1755= 0.0114
Weight of ordinary equity= 580/1755=0.3305
WACC= 11.53%*0.3305+6.47%*0.65811+10.5263%*0.0114
WACC= 8.1886%
2. Calculate the Detergent Division cost of capital, rounded to four decimal places.
Detergent division WACC = the general cost of debt and preferred stock+(equity beta of the
division*risk premium
=(2.5+1.20*7)*0.3305+ 6.47%*0.65811+10.5263%*0.0114
=7.9804%
3. Provide a valid reason to support Bowen for his estimate of the Detergent Divisions equity beta.
The estimation for the equity of Detergent Division is well informed because the industry average is
around the estimated figure in which specific adjustments have been made to reflect the riskiness of the
firm.
4. Explain whether the estimate of the divisional WACC would be higher or lower if Cream used detergent
industry capital structure to determine the divisional WACC.
The WACC using divisional capital structure= 0.1*8.1886=0.81886%. Therefore, WACC will be lower
and hence it will not represent the WACC for the division.
5. Calculate the NPVt=0 of the Big strategy using the appropriate discount rate.
NPV= total discounted cash flow- initial investment

ABCS COMPANY
Year
cash

Rate=9.9

flow

804%
-20000
4000
5000
6500
5000
4500
4000

0
1
2
3
4
5
6
NPVt=0

-20000
3637.011686
4133.704376
4886.157614
3417.502373
2796.636615
2260.311122
1131.323785

6. Using the appropriate discount rate, calculate the NPVt=1 of the expansion option.
NPVt=1
cash

Year

flow
0
1
2
3
4
5
6

0
-5,000
1500
1500
1500
1000
1000

NPVt=1

Rate=9.9804%
0
-4546.264607
1240.111313
1127.574834
1025.250712
621.4748033
565.0777805
33.22483528

7. Complete Table 3 fully, in accordance with the given assumptions, to show how the total after-tax cash
flows in year 0 to year 6 are derived.

Construction of the
after-tax cash flows
for Small without
expansion ($000)
t=0

t=1

t=2

t=3

t=4

t=5

t=6

ABCS COMPANY
Plant
Tax
Investment in working

-9000
0

0
0

0
0

0
0

0
0

0
0

4
1000
0

capital
Capital cash flow
Revenue
Variable cost
Fixed cost
Depreciation
Profit before tax
Tax (30%)
Profit after tax
Depreciation
Operating cash flow
Total after-tax cash

-400

-16

-16.64

-8.6528

-8.7072

450

-9400
0
0
0
0
0
0
0
0
0

-16
4000
1600
200
1500
700
210
490
1500
1990

-9400

1974 2033.56 2104.085 2132.6551 2169.82913

flow

-16.64
-8.6528
4160
4326.4
1664 1730.56
210
220.5
1500
1500
786
875.34
235.8 262.602
550.2 612.738
1500
1500
2050.2 2112.738

-8.7072
0
1450
4412.928
4500
4500
1765.1712
1800
1800
231.525 243.10125 255.256313
1500
1500
1500
916.2318 956.89875 944.743688
274.86954 287.069625 283.423106
641.36226 669.829125 661.320581
1500
1500
1500
2141.3623 2169.82913 2161.32058

8. Calculate the NPVt=0 of the Small strategy without expansion

cash

Year
0
1
2
3
4
5
6
NPVt=1

flow
-9400
1,974
2033.56
2104.085
2132.655
2169.829
3611.321

Rate=9.9804%
0
1794.865267
1681.227174
1581.67553
1457.670705
1348.494051
2040.677255
9904.609982

9. Calculate the NPVt=0 of the Small strategy with expansion included.

3611.32058

ABCS COMPANY
cash
Year
Rate=9.9804%
flow
0
-9400
0
1
1,974
1794.865267
2 -2966.44
-2452.477202
3 2104.085
1581.67553
4 2132.655
1457.670705
5 2169.829
1348.494051
6 2611.321
1475.599475
NPVt=0
5205.827826

10. Based on the total after-tax cash flows in Table 3, calculate the economic depreciation in year 1 for the
Small strategy without expansion.

cash

Year
0
1
2
3
4
5
6
NPVt=0

flow
-9400
-3,026
3533.56
3604.085
3632.655
3169.829
3611.321

Rate=9.9804%
0
-2751.39934
2921.338487
2709.250364
2482.921417
1969.968854
2040.677255
9372.757037

11. Calculate the value of the abandonment option at t=0 if the Small strategy without expansion could be sold
to another company for $9.5 million at the beginning of year 2.

ABCS COMPANY
6
Value of abandonment =(The Present value of selling amount + Present value of cash flows up to the year of
abandonment) (NPV of the project up to the end + initial cash outflow)
(1794.865267+8637.902754)(9904.609982+9400) = -8871.841961
12. Calculate algebraically the break-even annual sales revenue for the Small strategy without expansion.
Assume the project cost of capital to be 10% and a zero growth rate for both sales and fixed costs in all years.
Other factors and assumptions remain unchanged.

BEP (Dollar) = fixed cost /CMR

= (200+1500)/ (4000 1600)/4000*4.3553
=$12,340.01667
13. Based on ABCs financial position at 31/12/2015, how would ABC finance the detergent project? Name only
one specific source of finance from the balance sheet and the amount required. [General answer such as debt or
equity will not be acceptable]
The company should finance this expansion project by issuing additional preferred shares worth $20
million because it is cheaper and convenient in terms of paying returns and does not dilute the control of
other existing shareholders.
14. Calculate ABCs expected EPS, with four decimal places, for year 2016 if the company bought back all its
preference shares on 01/01/2016 at a value of $95 by raising the same amount of new bank overdrafts.

Projected before-tax profit (69/0.7)

$98.5714million

Less additional interest expense(8.5%*95*200,000) $1.6150million

Earnings before tax
Less tax @ 30%
Net profit

$96.9564 million
(29.08692 million)
67.86948 million

Expected Earnings per share = Total earnings / outstanding shares

= 67.86948 million/2000 million
= $0.0339 per share

ABCS COMPANY
7
15. Calculate ABCs expected EPS, with four decimal places, for year 2016 if the company issued sufficient new
ordinary shares to redeem all outstanding bonds at face value on 01/01/2016.

Projected before-tax profit (69/0.7)

$98.5714million

Reduction in interest expense (9%*575 million) $51.7500million

Earnings before tax

$150.3214 million

Less tax @ 30%

Net profit

(45.0942 million)
105.22498 million

Expected Earnings per share = Total earnings / outstanding shares

=105.22498 million/(2000 million+ 575/0.29 million)
= 105.22498 million /3982.758662
= $0.0264 per share
16. Apart from the impact on EPS, suggest two valid reasons for ABC not to issue new ordinary shares to replace
its long-term debt.
The main reason is to avoid dilution of control in the company because the new issue of shares would mean
reducing their voting powers in important decisions of the company.
17. Explain whether ABC should restart its dividend payout in 2016 and the reason.
The company should start the dividend payout in the year 2016. This is because the company has at least
finished most of the major investment decisions. This is also to make investors to be loyal and earn the value of
their investments in the company.