Rolls Royce Corporation is a manufacturer and dealer of hardware components and engines used in commercial planes. Currently, the directors are considering replacement of a major production equipment 2

Rolls Royce Corporation is a manufacturer and dealer of hardware components and engines used in commercial planes. Currently, the directors are considering replacement of a major production equipment used to manufacture the hardware components. The equipment will cost $250,000,000 and has a capacity to produce 5,000 hardware components per year for the next ten years. The variable cost of production is $12,500 per component and a selling price of $40,000 per component. Fixed cost per year will be $25,000,000 for the foreseeable future. Roll Royce Corporation will need $20,000,00 net working capital per year to undertake this investment. The entity’s weighted average cost of capital is 15%. Inflation in the economy is expected to be 5% for the foreseeable future. Depreciation is provided for on a straight-line basis and taxes are paid at the marginal rate of 30%. The directors may expand the investment if it is viable in the second year and the volatility of cash flow is 30% and the risk-free rate is at least equal to the rate of inflation. The directors also decided to finance fifty percent of the investment with debt finance by issuing ten-year 12% coupon bonds redeemable at 10% premium. Rolls Royce forecast earnings per share have been estimated at $48 and dividend of $18 per share will be paid to shareholders. Cost of equity before debt financing has been estimated at 18% using the capital asset pricing model. Divided has been growing at a constant rate of 6% per year and is expected to remain so for the foreseeable future. A one-year call option on the shares has an exercise price of $180 and the options will be valued using discrete time option pricing model.

Required – Compute the following:

1.     Present value of bonds

2.     Present value of shares

3.     Cost of equity after debt issue

4.     Present value of call options on the shares

5.     Present value of put options on the shares

6.     Payback period

7.     Return on investment

8.     Return on capital employed

9.     Economic value added

10. Net present value

11. Internal rate of return

12. Modified internal rate of return

13. Adjusted present value

14. The option to expand the investment

15. The investment value at risk

16. The expected loss on the investment

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