Capital Budgeting/ Cost of Capital

Shell Solar Water Inc. (SSI) is a market leader in the production and distribution of solar water heating systems throughout the OECS.The company is considering establishing a production plant on the island of Grand Cayman to decrease the cost of its operations. SSI had already purchased some land two years ago for $1,500,000 on which it plans to build its new plant which costs $4,000,000 to house its manufacturing business.The legal fee attached to this purchase was $120,000 and the company believes it can recover this cost through the sales of its systems which it expects to be more than what it currently enjoys.The company uses a CCA rate of 8 percent for the amortizing of its plant which can be scrapped for $780,000 at the end of the project life.

SSI conducted intense market research of two other islands before deciding on opening the plant in Grand Cayman and this research exercise cost the company $70,000.A valuation of the land shows that the land is now worth $3,000,000 because an upscale residential housing facility has been earmarked in the same town of the proposed plant site.This new residential area is projected to increase the firms future cash flows by 15 percent in the first two years and 20 percent in years 3 to 5.The project will last for five years, after which SSI will decide on the way forward.

Equipment used in the production of the systems will cost the company $800,000 and they shall be amortized at a CCA rate of 14 percent. The salvage value of the equipment at the end of the project will be $120,000 and which the company plans to sell to recover some of its expenses.

The company’s current market information on its securities is available below for your information:

Debt Currently selling for 94 percent of par, and pays semi-annual interest.28,000 8 percent coupon bonds are outstanding with 10 years to maturity, Yield to Maturity is 8.92 percent.
Common Stock Selling for $60.00 per share and has a beta of 1.4. Outstanding amount 350,000
Preferred Stock 22,000 shares, 5 percent preferred outstanding and is selling for $70 per share
Market Risk Premium 8 percent and treasury bills trade at 6 percent

First Citizens Investment Services Ltd (FCIS) is the lead broker for SSI and highly recommends that SSI issues new shares of common stock to raise the required funds to start the business, instead of using its retained earnings.

The company would need some cash in the sum of $400,000 to take care of its initial expenses in setting up the operation and to meet its client demands for the new systems.At the moment the tax rate for SSI is 25 percent.The board of directors of the company has decided that it will raise all equity for new projects using external funding.

Other relevant information is as follows:

a. The company will incur $400,000 in annual fixed costs,

b. The plant will produce 800 systems per year and sold for $3,000 per system.

c. The annual variable costs are $1,200 per unit

Mr. Brown is the CEO of SSI and has hired you as a financial consultant who will work along with the chief financial officer of the company to determine the Net Present Value of undertaking this new project and to advise whether SSI should set up operations in Grand Cayman.

In preparing your report, you should attempt to:

1. Calculate the initial investment’s cashflows as at time 0.(3 marks)

2. Determine the appropriate discount rate to evaluate the project.(round your answer to the nearest percentage.)(10 marks)

3. Calculate the present value of the CCA tax shield adjusted for the salvage value of the plant.(8 marks)

4. Calculate the present value of the CCA tax shield adjusted for the salvage value of the equipment.(8 marks)

5.Determine the present value of after-tax operating cash flows.(8 marks)

6. Calculate the present value of the net working capital.(3 marks)

7. Determine the Net Present Value and advise the company on what they should do.

(5 marks)

8. Assess the types of risks that SSI is likely to face by investing abroad. (5 marks)