The following table is given

INVESTMENT PLAN
Construction

2001
4.00

2002
4.00

2003
-

2004
-

2005
-

Total
8.00

Equipment for research center

13.00

11.00

6.00

3.00

2.00

35.00

Equipment for new production unit

14.00

16.00

5.00

35.00

Equipment for existing manufacturing

unit
Equity participation

15.00

15.00

8.00

6.00

6.00

50.00

8.00

4.00

12.00

Working capital

1.00

1.00

2.00

3.00

3.00

10.00

55.00

51.00

21.00

12.00

11.00

150.00

Total

1. DEPRECIATION
The depreciation of each category

)
(

DEPRECIATION SCHEDULE

2001

2002

2003

2004

2005

Total

Construction

0.20

0.40

0.40

0.40

0.40

1.80

Ordinary material and Equipment

3.36

6.72

8.24

8.96

9.60

36.88

Sophisticated material and Equipment

8.40

16.80

20.60

14.00

7.20

67.00

Total

11.96

23.92

29.24

23.36

17.20

105.68

Depreciation of the previous years

5.00

5.00

5.00

5.00

5.00

25.00

16.96

28.92

34.24

28.36

22.20

130.68

Annual depreciation

2. DEBT REPAYMENT
a. Loan 10 mil Euro, interest 10%, repayment from 1997 (Equal principal repayment method)
YEAR
1997
1998
1999
2000
2001
2002

BEGINNING
BALANCE
10,000
9,000
8,000
7,000
6,000
5,000

INTEREST
1,100
990
880
770
660
550

EQUAL
PRINCIPAL
PAYMENT
1,000
1,000
1,000
1,000
1,000
1,000

TOTAL
PAYMENT
2,100
1,990
1,880
1,770
1,660
1,550

OUTSTANDING
BALANCE
9,000
8,000
7,000
6,000
5,000
4,000

2003
2004
2005
2006
Similarly,

4,000
3,000
2,000
1,000

440
330
220
110

1,000
1,000
1,000
1,000

1,440
1,330
1,220
1,110

3,000
2,000
1,000
0

b. Loan 5 mil Euro, interest 11.5%, repayment from 1998 (Equal principal repayment method)
YEAR

BEGINNING
BALANCE

INTEREST

EQUAL PRINCIPAL
PAYMENT

TOTAL
PAYMENT

OUTSTANDING
BALANCE

1998
1999
2000
2001
2002
2003
2004
2005
2006
2007

5,000.0
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500

575.0
495
440
385
330
275
220
165
110
55

500.0
500.0
500.0
500.0
500.0
500.0
500.0
500.0
500.0
500.0

1,075.0
995.0
940.0
885.0
830.0
775.0
720.0
665.0
610.0
555.0

4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
-

c. Loan 5 mil Euro, interest 10%, repayment from 1999 (Equal principal repayment method)
YEAR

BEGINNING
BALANCE

1999
2000
2001
2002
2003
2004
2005
2006
2007
2008

5000
4500
4000
3500
3000
2500
2000
1500
1000
500

INTEREST
500
495
440
385
330
275
220
165
110
55

EQUAL PRINCIPAL
PAYMENT
500
500
500
500
500
500
500
500
500
500

TOTAL
PAYMENT

OUTSTANDING
BALANCE

1000
995
940
885
830
775
720
665
610
555

4500
4000
3500
3000
2500
2000
1500
1000
500
0

d. Loan 5 mil Euro, interest 8.5%, repayment from 2000 (Equal principal repayment method)
YEAR
1999
2000
2001
2002
2003
2004

BEGINNING
BALANCE
5000
4500
4000
3500
3000
2500

INTEREST
500
495
440
385
330
275

EQUAL PRINCIPAL
PAYMENT

TOTAL
PAYMENT

OUTSTANDING
BALANCE

500
500
500
500
500
500

1000
995
940
885
830
775

4500
4000
3500
3000
2500
2000

2005
2006
2007
2008

2000
1500
1000
500

220
165
110
55

500
500
500
500

720
665
610
555

1500
1000
500
0

e. Loan 10 mil Euro, interest 7.0%, repayment from 2002 (Equal principal repayment method)
YEAR

BEGINNING
BALANCE

2002
2003
2004

10,000.0
6,667
3,333

INTEREST

EQUAL
PRINCIPAL
PAYMENT

700.0
466.7
233.3

TOTAL
PAYMENT

3,333.33
3,333.33
3,333.33

OUTSTANDING
BALANCE

4,033.3
3,800.0
3,566.7

6,667
3,333
-

To sum up, total debt payment each year can be shown as the following table
Year
Total debt payment Amount

1997

1998

1999

2000

2001

2002

2003

2004

1,100.0 1,565.0 1,875.0 2,130.0 1,867.5 2,305.0 1,809.2 1,313.3

Based on given assumptions of hypothesis 1 and 2, we can build up the following table
Hypothesis 1
2001

2002

2003

2004

2005

Total

128.20

141.20

157.95

189.50

227.50

844.35

EBITDA

38.46

36.71

37.91

41.69

50.05

204.82

- Depreciation

16.96

28.92

34.24

28.36

22.20

130.68

EBIT

21.50

7.79

3.67

13.33

27.85

74.14

1.87

2.31

1.81

1.31

0.82

8.11

19.63

5.49

1.86

12.02

27.03

66.03

5.89

1.65

0.56

3.61

8.11

19.81

Net Income

13.74

3.84

1.30

8.41

18.92

46.22

+ Depreciation

16.96

28.92

34.24

28.36

22.20

130.68

Operating Cash flow

30.70

32.76

35.54

36.77

41.12

176.90

Sales (Forecasted)

- Interest expense
EBT
- Corporate income tax

Hypothesis 2
2001

2002

2003

2004

2005

Total

Sales (Forecasted)

128.20

141.20

157.95

189.50

227.50

844.35

EBITDA

26.92

29.65

33.17

34.11

40.95

164.80

- Depreciation

16.96

28.92

34.24

28.36

22.20

130.68

EBIT

9.96

0.73

(1.07)

5.75

18.75

34.12

- Interest expense

1.87

2.31

1.81

1.31

0.82

8.11

EBT

8.09

(1.57)

(2.88)

4.44

17.93

26.01

- Corporate income tax

2.43

(0.47)

(0.86)

1.33

5.38

7.80

Net Income

5.67

(1.10)

(2.02)

3.11

12.55

18.21

+ Depreciation

16.96

28.92

34.24

28.36

22.20

130.68

Operating Cash flow

22.63

27.82

32.22

31.47

34.75

148.89

2005
817.5

Comments:
The sales increases around 10% to 11% in the first two periods, 2001-2002 and 2002-2003, then it doubles the
grow rate to 20% in the following period.
In hypothesis 1 the EBITDA (as percentage of sales) is better than hypothesis 2, this implies the differences
between COGS and administrative expenses between the two scenarios.
The short useful life of ordinary material (3 years) and sophisticated material (5 years) lead to huge amount of
depreciation relative to EBITDA. Therefore, the EBIT decreases remarkably from 2001 to 2003 than rises again
later years. The case is worse in hypothesis 2, EBIT is lower (even negative value) for this pessimistic situation.
This result has positive impact of creating a tax shield (lower income, lower tax) for the company but also shows a
discourage the investors by the poor performance.
However the nagative effect of high depreciation in calculating net income is excluded in the operating cash flow
calculations. Because the depreciation is non-cash activity so this amount is added back to CFO (Cash Flow from
Operating activities). This make a smooth and quite reasonable CFO for the company which grows from 30.70 mil
in 2001 to 41.12 in hypothesis 1 and 22.63 mil to 34.74 accordingly for hypothesis 2

3. FUND NEEDS

Investment
Debt Repayment
Dividends
Total fund needs
Operating Cash flow
Yearly needs

Investment
Debt Repayment
Dividends
Total fund needs
Operating Cash flow
Yearly needs

2001
55.00
2.50
5.00
62.50

Hypothesis 1
2002 2003
51.00 21.00
5.83
5.83
5.00
5.00
61.83 31.83

2004
12.00
5.83
5.00
22.83

2005
11.00
2.50
5.00
18.50

Total
150.00
22.50
25.00
197.50

35.54
-3.71

36.77
-13.94

41.12
-22.62

176.90
20.60

Hypothesis 2
2001 2002
2003
55.00 51.00 21.00
2.50
5.83
5.83
5.00
5.00
5.00
62.50 61.83 31.83

2004
12.00
5.83
5.00
22.83

2005
11.00
2.50
5.00
18.50

Total
150.00
22.50
25.00
197.50

22.63
39.87

31.47
-8.63

34.75
-16.25

148.89
48.61

30.70
31.80

32.76
29.07

27.82
34.01

32.22
-0.39

Comments:
The investment plan requires the company to spend large amount on construction, equipment in the first two
years with total amount of 55 mil and 51 mil, respectively. Besides, the company must fulfill their obligations to
repay debt and dividends.
There are 2 options to solve the difficulties and the company has to make a rational choice after comparing the
cost of debt and cost of equity.
a. Option 1 - Loan funding: The company can borrow at the rate 7.5% if the debt/equity is lower than 1. If
debt/equity is above 1 then the rate increases.
b. Option 2 Stock issuing: The company can issue equity to meet funding needs

Normally, the cost of debt is lower than the cost of equity for these followng reasons

1.
2.
3.
4.
5.
6.

High risk equity requires higher returns, that means higher cost of equity.
Tax is deductible, after-tax cost of debt is lower by the formula Kd after-tax = Kd-before-tax * (1-tax rate)
Debt is secured against assets
Shareholders face both business risk and financial risk, while debt holders face only business risk.
The interest payment of the company is fixed and certain while the dividends for shareholder is uncertain.
In case of liquidation, the debtholders have better claim priority relative to shareholders.

We consider further details in this situation by using the CAPM model to estimate the cost of equity
Remind that
(
(

At low Debt/Equity level, the firm can make use of loan funding since the cost of debt is quite low. However, when this
ratio increases, the debtholder will add more default risk premium to the rate required as they feel more risky to lend
out the money. Therefore, when this risk premium is considerably high, the cost of debt will outnumber the cost of
equity. The firm should determine the optimal mix of debt financing and equity financing so that the cost of capital is
at minimum.

4. COMPANY VALUATION
We use the Discounted Cash Flow model to estimate the value of the company. In order to use this model we have to
assume some key factors like the following
a. Cost of debt

Loan Funding
Interest rate
10Mil EUR in 1996- 10 years
11%
5Mil EUR in 1997- 10 years
11.5%
5Mil EUR in 1998- 10 years
10%
5Mil EUR in 1999- 10 years
8.5%
10Mil EUR in 2000- 3 years
7.0%
15Mil EUR in 2001- 4 years
7.5%
20Mil EUR in 2001- 4 years
7.5%
Total interest expenses (mil)
Total debts
Cost of debts

Hypothesis 1

Hypothesis 2

Interest expenses
0.55
0.33
0.39
0.34
0.70
1.13
3.43
40
8.58%

Interest exprenses
0.55
0.33
0.39
0.34
0.70
1.50
3.80
45
8.46%

b. Cost of equity
(

c. Weighted average cost of capital

Recall that
(

Hypothesis 1

Equity
Debt
Total capital
Equity Weight
Debt Weight
Cost of Equity
Cost of Debt
Tax
WACC

Hypothesis 2

38
40
78
49%
51%
14.8%
9%
30%
10.3%

50
45
95
53%
47%
14.8%
8%
30%
10.6%

According to the DCF Model

)
)

(
(

Hypothesis 1
Free Cash Flows (FCFs)
WACC
Growth rate
Discounted FCFs 5 years
Discounted Terminal value
FIRM VALUE

2001
10.42
10.3%
7.00%
21.99
467.25
489.23

2002
-6.17

2003
0.13

2004
12.89

2005
14.36

Hypothesis 1
Free Cash Flows (FCFs)
WACC
Growth rate
Discounted FCFs 5 years
Discounted Terminal value
FIRM VALUE

2001
19.08
10.6%
5.00%
17.83
234.10
251.93

2002
-11.38

2003
-3.45

2004
7.32

2005
12.47

Comments:
In hypothesis 1, if we assume the growth rate is 7% the firm value will be approximately 489 mil, comparing with
the considerably lower value of 251 mil whne the growth rate is 5% in hypothesis 2
The limitation of this assumption is perpetual growth rate. In fact, the penetration of new competitors, the
economic conditions and various externalities will have great impact on the growth rate of the company