Assignemnt
Chapter 13: Risk and Return, and Capital Budgeting
Case Study
You have been hired as a financial consultant to Biopharmacy CompuNet Corporation (BCNC), a large, publicly traded firm that is the market share leader in biopharmaceutical computer information systems (BCIS). The company is looking at setting up a manufacturing plant overseas to produce a new line of BCIS. This will be a five-year project. The company bought some land three years ago for $4 million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. The land was appraised last week for $5.1 million.
In five years, the after-tax value of the land will be $6 million, but the company expects to keep the land for a future project. The company wants to build its new manufacturing plant on this land; the plant and equipment will cost $35 million to build. The following market data on BCNC's securities are current:
Debt: 240,000 7.5% coupon bonds outstanding, 20 years to maturity, selling for 94% of par; the bonds have a $1,000 par value each and make semiannual payments.
Common stock: 9,000,000 shares outstanding, selling for $71 per share; the beta is 1.2. Preferred stock: 400,000 shares of 5.5% preferred stock outstanding, selling for $81 per share.
Market: 8% expected market risk premium; 5% risk-free rate.
BCNC uses C. D. Capital as its lead underwriter. Capital charges BCNC spreads of 8% on new common stock issues, 6% on new preferred stock issues, and 4% on new debt issues. Capital has included all direct and indirect issuance costs (along with its profit) in setting these spreads. Capital has recommended to BCNC that it raise the funds needed to build the plant by issuing new shares of common stock. BCNC's tax rate is 35%.
The project requires $1,300,000 in initial net working Capital investment to get operational. Assume Capital raises all equity for new projects externally.
a. Calculate the project's initial time 0 cash flow, taking into account all side effects.
b. The new BCIS project is somewhat riskier than a typical project for BCNC, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of + 2% to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating BCNC's project.
c. The manufacturing plant has an eight-year tax life, and BCNC uses straight-line depreciation. At the end of the project (that is, the end of year five), the plant and equipment can be scrapped for $6 million. What is the after-tax salvage value of this plant and equipment?
d. The company will incur $7,000,000 in annual fixed costs. The plan is to manufacture 18,000 BCISs per year and sell them at $10,900 per machine; the variable production costs are $9,400 per BCIS. What is the annual operating cash flow (OCF) from this project?
e. BCNC's comptroller is primarily interested in the impact of BCNC's investments on the bottom line of reported accounting statements. What will you tell her is the accounting break-even quantity of BCISs sold for this project?
f. Finally, BCNC's president wants you to throw all your calculations, assumptions, and everything else into the report for the chief financial officer; all he wants to know is what the BCIS project's internal rate of return (IRR) and net present value (NPV) are. What will you report?