Financial Decision Making for Richside Industries

This text discusses the financial decision making process for Richside Industries, including the computation of net present value and weighted average cost of capital. It covers aspects such as sunk costs, depreciation charges, and the exclusion of certain expenses. The text also provides a step-by-step guide to computing the cost of equity and post-tax cost of debentures, as well as the weights of various sources of capital. Finally, it concludes with the computation of the before tax interest on a mortgage loan.

FINANCIAL DECISION MAKING
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Question 1
In order to determine if RIchside Industries should go ahead with the project or not, Net
present value or NPV of the project needs to be found.
In order to compute the same, the following aspects are noteworthy.
 The amount spent on the feasibility study to the extent of $ 50,000 would not be
considered in the NPV analysis as it is a sunk cost which cannot be recovered
irrespective of the decision undertaken.
 Annual depreciation charges as per straight line method = 1000000/10 = $ 100,000
 The head office expense loading would not he considered since it is not an
incremental cost.
 Also, the interest expenses would be excluded since the impact of the same is
reflected in the cost of capital.
 It has been assumed that the salvage value of the plant is zero at the end of the useful
life of the project.
 Also, it has been assumed that initial raw material and inventory related working
capital would not be recovered at the end of the project.
 Further, it has been assumed that the land would now be sold after10 years and the
selling price would be same as $ 500,000.
The NPV of the given project can be estimated as shown below.
Since the NPV of the project is negative as apparent from the above computations, the
company should not go ahead with the project.

Question 2
It is known that the weighted average cost of capital is 13.635%.
Cost of various sources of capital
The cost of equity can be computed using the CAPM approach indicated below.
Cost of equity = Risk Free Rate + Beta*(Market Return – Risk free Rate)
Hence, cost of equity = 12 + 0.7*(20-12) = 17.6 % p.a.
Post tax cost of debentures = 13*(1-0.4) = 7.8% p.a.
Let the pre-tax interest rate on mortgage loanbe X %
Then post tax cost of
Weights of various sources of capital
Market value of equity = $ 6 million
Market value of debentures = $ 2.5 million
Market value of mortgage loan = $ 1.5 million
Total market value of capital = 6+ 2.5 + 1.5 = $ 10 million
Weight of equity = (6/10)*100 = 60%
Weight of debentures = (2.5/10)*100 = 25%
Weight of mortgage loan = (1.5/10)*100 = 15%
Computation of cost of mortgage
WACC is obtained by the sum of the respective products of weights and cost of the different
sources of financing availed by the company.
0.6*17.6 + 0.25*7.8 + 0.15*X(1-0.4) = 13.635
Solving the above, we get X = 12.5% p.a.
Hence, it may be concluded that the before tax interest on mortgage loan is 12.5% p.a.