Financial Decision Making for Richside Industries

This article discusses the financial decision making process for Richside Industries, including the computation of project NPV and WACC. It also includes sources and weights computation for equity, debentures, and mortgage loan.

FINANCIAL DECISION MAKING
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Question 1
The key objective is to decide if the given project should be gone ahead with by Richside
Industries. In order to opine on the same, the project NPV (Net Present Value) is to be found
considering the following.
 Feasibility study related cost to the tune of $ 50,000 would be sunk cost and hence no
included in the incremental cash flow and related NPV determination. This cost has
already been incurred and would not be recovered irrespective of the decision
regarding the project (Damodaran, 2015).
 The depreciation on the plant would be charged using straight line method over the 10
year period with zero salvage value.
Hence, depreciation expense per year = (1000000/10) = $ 100,000
 The expenses related to head office that are allocated are not actually incurred and
would not even result in incremental tax deduction. Thus, these are ignored from the
analysis.
 NPV analysis does not consider the impact of interest payments and hence these are
ignored for the given analysis as well. The effect of interest rate is captured through
cost of capital (Parrino and Kidwell, 2014).
 An assumption has been made that the incremental working capital in the form of
inventory and raw material is not recoverable at the project end and thereby would be
consumed.
 Another assumption made is that the project land would be liquidated after the project
is over and the market value of land then would be same as market value today i.e. $
500,000. Also, it is assumed that the land would have no associated capital gains
when it is liquidated at the end of project.
The project related NPV using a cost of capital as 15% is indicated as follows.

The above computation clearly reflects that project NPV is negative and thereby the project
should not be initiated by the company as it would destroy wealth of shareholders
(Damodaaran, 2015).
Question 2
The WACC of the company has been provided as 13.635%..
Cost Computation - Sources of capital
The CAPM approach deploys the following formula for equity cost computation (Parrino and
Kidwell, 2014).
Therefore, cost of equity of the company = 12 + 0.7*(20-12) = 17.6 % p.a.
Debenture cost (After tax) = 13*(1-0.4) = 7.8% p.a.
Consider that the interest rate on mortgage loan before tax is X %
Since, interest related tax deduction would be available, then the cost of mortgage loan post
tax = X (1-0.4) = 0.6X
Sources of capital – Weight Computation
Equity (Market value) = $ 6 million
Debentures (Market value) = $ 2.5 million
Mortgage loan (Market value) = $ 1.5 million

Cumulative capital (Market value) = 6+ 2.5 + 1.5 = $ 10 million
Equity (Weight) = (6/10)*100 or 60%
Debentures (Weight) = (2.5/10)*100 or 25%
Mortgage Loan (Weight) = (1.5/10)*100 or 15%
Cost of mortgage
The above equation when solved yields X as 12.5%
From the above computation, it has been derived that the mortgage loan interest on a pre-tax
basis is 12.5% p.a.

References
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons.
Parrino, R. & Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications