Question

Movilizarte is looking for options to expand its services focused on the elderly. They are evaluating a project that represents an investment of Bs285,000 at t=0. They estimate revenues of Bs375,000 per year for an indefinite period of time, with costs equivalent to 60% of revenues. The ISLR rate is 30% and the return on assets or required by the shareholders (without debt) is 32%.

a). Calculate the cash flows of the business assuming it is financed entirely with shareholders' equity.
b). Calculate the average cost of capital (Rwacc) assuming that a portion of the project can be financed with debt of Bs100,000 at 18% annual interest.
c). Calculate the net present value of the business assuming the financing conditions described in b (part of the project is financed with debt of Bs100,000 at 18% annual interest and the rest with shareholders' equity).

Answer 1

The cash flow of Movilizarte's business financed with equity is Bs105,000 per annum. To calculate the weighted average cost of capital (Rwacc), we consider the debt and equity proportions along with their respective costs and the tax rate. Finally, the net present value (NPV) is determined by dividing the annual cash flow by Rwacc and subtracting the initial investment not financed by debt. Option B is correct answer.

Step-by-step explanation:

To answer the student's question on Movilizarte's project evaluation, we carry out a financial analysis considering the provided data.

Part A: Calculating Cash Flows

First, let's calculate the annual cash flows:

1. Annual revenues: Bs375,000.
2. Costs are 60% of revenues, so costs = 0.60 * Bs375,000 = Bs225,000.
3. Annual profits before tax = Bs375,000 - Bs225,000 = Bs150,000.
4. Income tax (ISLR) at 30% on profits, so tax = 0.30 * Bs150,000 = Bs45,000.
5. Cash flow = Annual profits - Tax = Bs150,000 - Bs45,000 = Bs105,000.

Part B: Calculating Rwacc

Assuming part of the project is financed with debt:

• Amount financed with debt = Bs100,000.
• Interest rate on debt = 18%.
• We use the formula Rwacc = E/V * Re + D/V * Rd * (1 - Tc), where E is equity, V is total value, Re is cost of equity, D is debt, Rd is cost of debt, and Tc is tax rate.
• The equity portion is Bs285,000 - Bs100,000 = Bs185,000.
• Total value V = Bs285,000.
• Cost of equity Re = 32%.

Now we can calculate the weighted average cost of capital (Rwacc).

Part C: Calculating NPV

Finally, NPV is calculated using the formula NPV = (Cash Flows / Rwacc) - Initial investment.

1. Calculate cash flows as seen in Part A.
2. Use the Rwacc calculated in Part B as the discount rate.
3. Subtract the initial investment of Bs285,000.

Since the cash flows are perpetual, the formula becomes NPV = Cash Flows / Rwacc, and then we subtract the initial investment not financed by debt.