Case 6 High Mountain Technologies

1. What are the appropriate costs of capital for the GPS transmitter and
surveillance aircraft projects?
From the projects, HMT need to earn at least the required rate of return to
compensate the investors for the financing they have provided. The required rate of
return is same as the appropriate discount rate that use for calculating the net present
value (NPV). In order to estimate the discount rate for these projects, we need to
assume that the new project has the same risk as the existing business activities in the
firm. However, if the new project has the risks which are different from the existing
business, WACC is not suitable to apply in its estimation of cost of capital.
Since High Mountain Technologies Ltd. (HMT) is going to produce varies
innovative products across different industries, the risk involved in the projects will
definitely different with the HMT's existing business activities. Therefore, WACC is
not suitable for cost of capital calculation, but capital asset pricing model (CAPM).
CAPM is a model that describes the relationship between systematic risk and
expected return for assets. This model has involved the risk measure which is the beta
that compares the returns of the assets or portfolios to the market over a period of
time, and involved the market premium which is the return of the market risk in
excess of the risk-free rate. Therefore, HMT should use the CAPM to calculate GPS
transmitter project and surveillance aircraft projects’ cost of equity capital as discount
rate will reflect the risk inherent in the projects.

Cost of capital for GPS Transmitter project

First of all, we can acquire the equity beta by calculating the average equity beta
from the five companies that involved in microcomputer component manufacturing
industry.
Treasurysprea
Companies Beta
d
Sun Screen 1.75 4.01%
AMC Devices 1.62 3.81%
Sure Storage 1.49 3.56%
Amdahl Computers 1.93 4.34%
Dempsey Industries 1.54 3.85%
Average (βe) 1.666

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While for the debt beta, we assume that the debt to be risk free which means the debt
beta will be 0. After acquired of the debt beta and equity beta, we calculate the asset
beta by using the following formula:
βa = Wdβd + Weβe
d
Wd= = long term debt to total capital ratio = 40%
e +d

e
We= = equity to total capital ratio = 60%
e +d

βa = 0.4*0 + 0.6*1.666 = 0.9996

Next, we calculate the cost of capital of GPS transmitter project by using the formula
of CAPM as shown as below:

E(r )=rf + βa(rm−rf )

rf = risk free rate = 4%

( rm−rf ) = market risk premium = 5%

E(r ) = 0.04 + 0.9996 (0.05) = 0.08998

As HMT has limited experience in the microcomputer components industry, it

decided to add three percent to cost of capital of GPS transmitter project for additional
risk inherent in it. The HMT also had difficulty in raising new capital, so it generated
all new equity capital using retained earnings, and five percent cost of issuing new
equity will be added. Therefore the total cost of capital is 16.998%.

Cost of capital = 8.998%+3%+5% =16.998%

Cost of capital for Surveillance Aircraft Project

Since the surveillance aircraft industry was less developed as the technology was
relatively new, we are not using the average industrial beta as equity beta. We use the
Sky Hawk historical stock data as Sky Hawk was the only public company in this
industry with five years experiences. Firstly, we calculate the percentage change
period to period for both the Sky Hawk share price and Stock Index by using the
formula:

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 (New Price−Old Price)
Percentage change = x 100
Old Price

SKY HAWK historical stock data

Stock Stock Index Sky Hawk Sky Hawk share price
Period
Index percentage change share price percentage change
1 6003.56 61.21
2 6037.33 0.56% 62.32 1.81%
3 6154.88 1.95% 63.66 2.15%
4 6234.33 1.29% 64.38 1.13%
5 6450.67 3.47% 70 8.73%
6 6340.77 -1.70% 62.88 -10.17%
7 6120.88 -3.47% 59.27 -5.74%
8 5807.33 -5.12% 55.54 -6.29%
9 5783.78 -0.41% 54.31 -2.21%
10 5845.44 1.07% 56.65 4.31%
11 5965.44 2.05% 58.66 3.55%
12 5927.03 -0.64% 57.23 -2.44%
13 5803.34 -2.09% 55.87 -2.38%
14 6034.33 3.98% 58.48 4.67%
15 6100.93 1.10% 60.21 2.96%
16 6378.45 4.55% 64.32 6.83%
17 6456.33 1.22% 65.65 2.07%
18 6409.37 -0.73% 65.43 -0.34%
19 6543.55 2.09% 68.77 5.10%
20 6698.33 2.37% 71.34 3.74%
21 6703.87 0.08% 71.77 0.60%
22 6684.34 -0.29% 70.23 -2.15%
23 6834.95 2.25% 73.74 5.00%
24 6699.44 -1.98% 68.91 -6.55%
25 6584.5 -1.72% 65.45 -5.02%
26 6593.22 0.13% 66.86 2.15%
27 6534.56 -0.89% 64.34 -3.77%
28 6667.98 2.04% 67.34 4.66%
29 6490.88 -2.66% 62.68 -6.92%
30 6389.22 -1.57% 63.44 1.21%
31 6289.78 -1.56% 61.63 -2.85%
32 6305.53 0.25% 62.89 2.04%
33 6310.76 0.08% 63.87 1.56%
34 6450.33 2.21% 65.45 2.47%
35 6477.88 0.43% 65.87 0.64%
36 6485.94 0.12% 67.37 2.28%
37 6432.94 -0.82% 64.65 -4.04%

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 38 6600 2.60% 67.87 4.98%
39 6734.55 2.04% 69.01 1.68%
40 7321.34 8.71% 74.12 7.40%
41 7454.34 1.82% 75.85 2.33%
42 7645.48 2.56% 81.34 7.24%
43 7903.33 3.37% 73.98 -9.05%
44 8134.33 2.92% 78.74 6.43%
45 8234.33 1.23% 81.23 3.16%
46 8305.33 0.86% 84.65 4.21%
47 8300.87 -0.05% 84.78 0.15%
48 8413.75 1.36% 85.54 0.90%
49 8500.33 1.03% 86.44 1.05%
50 8700.34 2.35% 90.02 4.14%
51 8654 -0.53% 88.56 -1.62%
52 8778.3 1.44% 91.34 3.14%
53 8503 -3.14% 88.87 -2.70%
54 8876.33 4.39% 94.45 6.28%
55 8903.33 0.30% 93.87 -0.61%
56 9034.44 1.47% 94.33 0.49%
57 8953.33 -0.90% 94.67 0.36%
58 8957.32 0.04% 95.44 0.81%
59 9003.78 0.52% 95.88 0.46%
60 8933.68 -0.78% 94.56 -1.38%

As we know that equity beta is equal to covariance of the asset and the stock market
divide by variance of the asset as shown as the formula below:

β p=Cov(r p , r b)/Var ( r b)

Cov(r p , r b) = Covariance’s ( series of Sky Hawk share price percentage change,

series of stock index percentage change) = 0.000687861

Var (r b) = VAR.s (series of stock index percentage change) = 0.000495863

Β p = 0.000687861/0.000495863 = 1.38719896

Next, we assume that the debt to be risk free which means the debt beta will be 0.
After acquired of the debt beta and equity beta, we calculate the asset beta by using
the following formula:
βa = Wdβd + Weβe

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 d
Wd= = long term debt to total capital ratio = 40%
e +d

e
We= = equity to total capital ratio = 60%
e +d

βa = 0.4*0 + 0.6*1.38719896 = 0.832319376

Next, we calculate the cost of capital of surveillance aircraft project by using the
formula of CAPM as shown as below:

E(r )=rf + βa(rm−rf )

rf = risk free rate = 4%

( rm−rf ) = market risk premium = 5%

E(r ) = 0.04 + 0.832319376 (0.05) = 0.08162

While the issuing cost for new equity capital which is five percent will be added in the
cost of capital.

Cost of capital = 8.162% + 5% = 13.162%

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2. What are the net present values of the two projects?
In order to acquire the net present value, we have to calculate the operating cash flow for each project for ten years period.
GPS Transmitter projections
Year 0 1 2 3 4 5 6 7 8 9 10
sales unit 5,000 5,500 6,050 6,655 7,321 7,321 7,321 7,321 7,321 7,321
Prices 500 500 500 500 500 500 500 500 500 500
Revenue 2,500,000 2,750,000 3,025,000 3,327,500 3,660,250 3,660,250 3,660,250 3,660,250 3,660,250 3,660,250
Cost 350 350 350 350 350 350 350 350 350 350
COGS 1,750,000 1,925,000 2,117,500 2,329,250 2,562,175 2,562,175 2,562,175 2,562,175 2,562,175 2,562,175
Gross profit 750,000 825,000 907,500 998,250 1,098,075 1,098,075 1,098,075 1,098,075 1,098,075 1,098,075
Incremental selling and
750,000 750,000 750,000 750,000 750,000 750,000 750,000 750,000 750,000 750,000
administration
Corporate overhed 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000
Software maintenance 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000
Depreciation of patent 375,000 375,000 375,000 375,000
Depreciation of
1,000,000
software
EBIT (1,675,000) (600,000) (517,500) (426,750) 48,075 48,075 48,075 48,075 48,075 48,075
Tax (30%) - - - - 14,423 14,423 14,423 14,423 14,423 14,423
Net Income (1,675,000) (600,000) (517,500) (426,750) 33,653 33,653 33,653 33,653 33,653 33,653
Depreciation of patent 375,000 375,000 375,000 375,000
Depreciation of
1,000,000
software
operating cash flow - (300,000) (225,000) (142,500) (51,750) 33,653 33,653 33,653 33,653 33,653 33,653
Capital
purchase of patent (1,500,000)
purchase of software (1,000,000)

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changes in net working
(200,000) 200,000
capital
Total capital cash flow (2,700,000) - - - - - - - - - 200,000
projected cash flow (2,700,000) (300,000) (225,000) (142,500) (51,750) 33,653 33,653 33,653 33,653 33,653 233,653
WACC 17.00%
NPV (3,131,302)

Based on the case, capital cost allowance rate for patent was 25%, which means that the depreciation of patent is $375,000 per year and up to
Year 4. Meanwhile, the software will be written off immediately for tax purposes, which means it will be fully depreciated in year 1. For the year
1 to year 4, the earnings before interest and tax (EBIT) is negative. So, no tax payable existing in our calculation of NPV for the first four years.
After obtaining the net income, we added back the depreciation to find the operating cash flow. This is because depreciation is a non-cash
deduction. Besides of the operating cash flow, we also calculated the capital spending or initial outflow which included the purchase of patent,
software, and the investment of net working capital which will be liquidated at the end of the project. Lastly, we use the cost of capital to
discount the projected cash flow of GPS transmitter in order to get the NPV, which is negative $3,131,302.

Surveillance Aircraft projections

Year 0 1 2 3 4 5 6 7 8 9 10
sales unit 250 500 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000
price 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000
15,000,00 30,000,00 60,000,00 60,000,00 60,000,00 60,000,00 60,000,00 60,000,00 60,000,00 60,000,00
revenue
0 0 0 0 0 0 0 0 0 0
cost 54,000 54,000 54,000 54,000 54,000 54,000 54,000 54,000 54,000 54,000
COGS 13,500,00 27,000,00 54,000,00 54,000,00 54,000,00 54,000,00 54,000,00 54,000,00 54,000,00 54,000,00

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 0 0 0 0 0 0 0 0 0 0
Gross profit 1,500,000 3,000,000 6,000,000 6,000,000 6,000,000 6,000,000 6,000,000 6,000,000 6,000,000 6,000,000
Incremental selling and
2,500,000 2,500,000 2,500,000 2,500,000 2,500,000 2,500,000 2,500,000 2,500,000 2,500,000 2,500,000
administration
Incremental corporate
750,000 750,000 750,000 750,000 750,000 750,000 750,000 750,000 750,000 750,000
overhead
Depreciation of building
30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000
(4%)
Depreciation of equipment
300,000 300,000 300,000 300,000 300,000
(20%)
(2,080,00
EBIT (580,000) 2,420,000 2,420,000 2,420,000 2,720,000 2,720,000 2,720,000 2,720,000 2,720,000
0)
Tax (30%) - - 726,000 726,000 726,000 816,000 816,000 816,000 816,000 846,000
(2,080,00
Net Income (580,000) 1,694,000 1,694,000 1,694,000 1,904,000 1,904,000 1,904,000 1,904,000 1,874,000
0)
Depreciation of building
30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000
(4%)
Depreciation of equipment
300,000 300,000 300,000 300,000 300,000
(20%)
(1,750,00
Operating cash flow (250,000) 2,024,000 2,024,000 2,024,000 1,934,000 1,934,000 1,934,000 1,934,000 1,904,000
0)
Capital
Land (250,000) 450,000
Building (750,000) 300,000
(1,500,00
Equipment 150,000
0)
changes in net working
(350,000) 350,000
capital

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 (2,850,00
Total capital cash flow - - - - - - - - - 1,250,000
0)
(2,850,00 (1,750,00
Projected cash flow (250,000) 2,024,000 2,024,000 2,024,000 1,934,000 1,934,000 1,934,000 1,934,000 3,154,000
0) 0)
WACC 13.16%
NPV 3,135,684

Based on the case, the building was subjected to a capital cost allowance rate of 4%, which means that there are $30,000 depreciation cost on
building per year up to Year 10. The equipment was subjected to capital cost allowance rate of 20%, which means $300,000 depreciation cost on
equipment per year up to Year 5. After we calculated the EBIT, year 1 and year 2 do not incur any tax payable due to negative EBIT. However,
we had to calculate the adjustment on the tax payable due to the capital gain or loss on selling of the land, building and equipment at the end of
year 10. The calculation will be shown as below:

Book value = Depreciable asset – Total amount depreciated

Capital gain/loss = salvage value- book value

Tax adjustment
Building $ Equipment $ Land $
150000
750000 250,000
depreciable asset depreciable asset 0 depreciable asset
salvage value 300000 salvage value 150000 salvage value 450000
accumulated accumulated 150000 accumulated
300000 0
depreciated depreciated 0 depreciated
book value 450000 book value 0 book value 250,000

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 -
150000 200,000
capital loss 150000 capital gain capital gain
tax 30% tax 30% tax 30%
tax refund -45000 tax payment 45000 tax payment 30000

Projected tax of year 10 + tax on capital gain of equipment –tax refund on capital loss of building + tax on capital gain of land = adjusted tax
payable of year 10

$816,000 + $45,000 -$45,000 + $30,000 = $846,000

In year 10, the projected tax payment is $816,000. After the tax adjustment based on the capital gain or loss, the tax payable for year 10 is
$846,000. The non-cash outflow, which is depreciation of the building and equipment will be added back to obtain the operating cash flow. The
initial outflow such as the purchasing of land, building, equipment and changes of networking capital have been record in year 0. Moreover, the
salvage value of the building, land and equipment were added back at the last year. The WACC, 13.16% has been used as for the purpose of
NPV, which is positive $3,135,684.

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3. Which projects would you recommend to the NPRC? Why?
Based on the calculation above, we would recommend NPRC to take
Surveillance Aircraft project because it can generates positive net present value,
which is $3,135,684. It indicating this project will helps the company to earn profit
after two years period as the positive cash flow will be generated after second year.
However the GPS transmitter project has negative NPV, and long term negative cash
flow generating until year 5.

Besides of the positive NPV, the WACC, discounted rate of return also indicating the
surveillance aircraft project has lower risk if compared to GPS transmitter project.
This is because of the surveillance aircraft project’s WACC is 13.16% which is lower
than the GPS transmitter project’s WACC, 17%.

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