How do you solve this question?
Waltech, a firm that specializes in using marine renewable energy to generate electricity, is considering a project to construct a system of wave energy conversion devices called the 'Sapient'. The life of the project will be five years. A survey by Waltech, which cost $5 million, has shown that the efficiency of the Sapient may be high (probability 40%) or low (probability 60%). If the efficiency is high, the sales revenue from operating the Sapient will be $415 million in the first year and then grow at 6% each year. If it is low, the sales revenue will be $350 million in the first year and then grow at 6% each year.
Variable costs will be 35% of sales revenue. The fixed costs of operating the Sapient are estimated to be $16.5 million each year, excluding depreciation. The Sapient will cost $750 million and depreciation allowances for tax purposes will be 20% each year on a reducing-balance basis. The Sapient will be scrapped at the end of the project and the scrap proceeds are estimated to be $25 million. Any unused depreciation allowance will be immediately applicable when the machine is sold.
Working capital of $20 million will be required at the start of the project and after one year this requirement will increase to $25 million. All working capital will be recovered at the end of the project. If the Sapient project is undertaken, Waltech plans to pay an additional $12 million in dividends to its shareholders in each year of the project's life.
The corporation tax rate is 17% and tax is payable in the same year as taxable profit arises.
The CFO determines the risk-free rate to be 5% and the market return to be 12%. Based on the movement of the company's stock prices, beta is calculated to be 2.0. The company has a pre-tax cost of debt of 10%. Market value of equity comprises 70% while market value of debt comprises 30% of capital employed.
(a) Calculate the cost of capital that should be used to discount the project cash flows assuming that neither business nor financial risks of the company changes. (15 marks)
(b) Use the WACC calculated above to calculate the net present value (NPV) of the best case and worst case outcomes for the Sapient project, assuming investment would occur immediately. What is the expected net present value of the project? (60 marks)
(c) Assume that Waltech could make a payment now for a further study which will find out for certain how efficient the Sapient will be. The project start would be delayed for one year. What is the maximum amount Waltech should pay for the study? If the study costs $10 million, what is the net present value of the project? Should the project be undertaken? Explain. (25 marks)
