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Question 2 (30 marks)
EITC Ltd is a small shipping company that is considering upgrading its shipping capacity. At present the company owns and operates the Black Pearl as its main ship but is considering replacing it with a new ship called the Flying Dutchman, a much larger vessel. The CEO of EITC Ltd, Mr Cutler Beckett, has appointed you to evaluate the proposal for the Board. If the Board decides to go ahead with the project the Black Pearl will be immediately sold and replaced by the Flying Dutchman. The Flying Dutchman would then operate for 5 years.
Last year EITC Ltd commissioned the consulting group Swan and Co. to evaluate the potential of the new vessel. This report cost $500,000 and was delivered last month. The finance department of EITC used the findings of that report to provide you with the following information about the two vessels:
Black Pearl
1. Original purchase price: $15 million
2. Years since the purchase: 5 years
3. Depreciation rate: 15% per year
4. Salvage value this year: $2 million
5. Salvage value in 5 years: $300,000
6. Revenue each year: $6.5 million
7. Operating costs each year: $4.2 million
Flying Dutchman
1. Purchase price this year: $18 million
2. Depreciation rate: 12.5% per year
3. Estimated salvage value in 5 years: $10 million
4. Revenue each year: $10.8 million
5. Operating costs each year: $3.5 million
The following additional information is also available about EITC Ltd and the current market:
1. EITC has $60 million in market value of debt, $30 million in market value of preference shares and $60 million in market value of ordinary shares.
2. EITC has an equity beta of 1.4
3. EITC borrows debt capital at a cost of 6% pa above the Commonwealth bond yield
4. EITC’s 10% preference shares have a par value of $2 and are currently trading at $1.25. The dividends on the preference shares are unfranked.
5. The market...