Introduction
The capital budgeting decision is one of the most important financial decisions in business firms. General Enterprises Corporation (GEC) is considering whether to invest in a new production system. To determine if the project is profitable, GEC must first determine the weighted average cost of capital to finance the project. The simple payback period, discounted payback period, net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR) techniques are used to study the profitability of the project. The stand-alone risk of the project is evaluated with the sensitivity analysis and scenario analysis techniques assuming that manufacturing the new product would not affect the current market risk of the company.
Requirements
Follow the details and the instructions given throughout the case. You are asked to compute the weighted average cost of capital, determine the project’s cash flows, evaluate the project using different techniques, and perform the sensitivity and scenario analysis. Please, type and show your work.
Ethical conduct
While, you can work together,if I determine that this assignment was not written solely by the student whose name appears on the project, the grade for this case study will be zero.
Case study presentation
General Enterprises Corporation (GEC) is planning to invest in a special manufacturing system to produce a new product. The invoice price of the system is $280,000. It would require $10,000 in shipping expenses and $10,000 in installation costs. The system falls in MACRS 3-year class with depreciation rates of 33% for the first year, 45% for the second year and 15% for the third year. GEC plans to use the system for four years and it is expected to have a salvage value of $40,000 after four years of use.
GEC expects the new system to generate sales of 1,600 units per year. The company estimates that the new product will sell for $260 per unit in the first year with a cost of $160 per unit, excluding depreciation. Management projects that both the sale price and the cost per unit will increase by 3% per year due to inflation.GEC’s net operating working capital would have to increase by $60,000. The firm’s marginal tax rate is 40%.
You are conducting the capital budgeting analysis for the project. Your first task is to estimate the company’s WACC.
A. Estimate the company’s WACC
• You can determine the yield to maturity (YTM) on the company outstanding bonds by using their current market prices. It can be assumed that the company will be able to issue additional bonds with this YTM as the cost of borrowing. The company should be able to place the new bonds without any flotation costs.
• The company’s capital structure is: 30% debt, 10% preferred stock and 60%. The company has about $80,000 in retained earnings this year, which is also available in cash. The company should be able to use this year’s retained earnings to finance part of the equity financing required for the project. However, the company will have to issue some new common shares for the remainder of the necessary equity financing. It can be assumed that flotation costs are about 10% for the new common shares.
• There are three basic methods of calculating a firm’s cost of equity when retained earnings are used as equity capital: 1) the capital asset pricing method (CAPM); 2) the discounted cash flow (DCF) approach; and, 3) the bond-yield-plus-risk-premium method. Although there are three methods, the most appropriate approach for this company would be to find an average cost with the three methods.
• The data neededto estimate the firm’sWACC.Itprovidesthe data required tocalculate thecost of debt, thecost ofpreferred stock and thecost of commonstock.The amount of newcommon stock to be issuedisprovided at the end of theexhibit.
General’scurrentmarketvalue optimal capitalstructure:
Weight
Bonds $30,000,000 30%
Preferred Stock 10,000,000 10%
Common Equity 60,000,000 60%
Data to be used in the calculation of the cost of borrowing with bonds:
Par value =$1,000, non-callable
Market value =$1,085.59
Coupon interest=8%, semiannual payment
Remaining maturity=10years
New bond scan be privately placed without any flotation costs
Data to be used in the calculation of the cost of preferred stock:
Par value =$100
Annual dividend=8%ofpar
Market value =$102
Flotation cost =4%
B Analysis of the Profitability of the Project
• With the sales and cost estimates given below,you should be able to estimate the project’s cashflows for the four-year horizon. You should be able to compute the NPV, IRR, MIRR, simple payback period, and discounted payback period results for the project
This table shows the data needed to calculate the cash flows for this project. The new production system has useful lifeof4 years, asalvagevalue of $40,000 and fallsin MACRS 3-yearclass.Annual revenue and cost estimates are presented in the middle of the table. The system is expected to generate sales of 1,600 units per year, with a unit price of $260 and unit cost of $160.General’snet operating working capital requirement is $60,000.
C. RiskAnalysis
After you submitted the cash flow calculations and the project profitability analysis results, you have to perform the risk analysis for the project.
• Since the new product will be similar to the company's existing products ,you do not believe the new project will change the company's be taanditsover all market risk.Therefore,it should be sufficient to evaluate the stand-alone risk of the project. What are the techniques that we can use to assess the stand-alone risk of a project?
• Sensitivity analysis is a wide loused technique to determine how much a project's NPV will change in response to a given change in an input variable.Input variable s such as sales or the cost of capital are of ten used while holding other things constant.
• Sales figure s are difficult to forecast with a high degree of accuracy.It should be sufficient to evaluate the impact of an increase ora decrease of 15% insalesand costs from the base forecast. Compute the NPV for a 15% increase in sales and costs, and for a 15 % decrease.
• The actual WACC figure is also likely to deviate from the expected base level. You would like to know how sensitive the project's NPV is to an increase or decrease of 1.5% in the WACC. Compute the NPV considering the base sale and costs figures for an increase and decrease of 1.5% in WACC.
• Another analysis technique for project risk used in practice is scenario analysis. In this technique,the best and worst-case NPVscenarios are compared with the project's expected NPV. As the best-case scenario, assume that the sale s and costs fore cast will be 15% higher and the WACC will be 1.5% lower than our original estimates .Forthe worst-case scenario, assume that the sales forecast will be 15% lower and the WACC will be 1.5% higher. Please calculate the standard deviationand the coefficient of variation of the project's NPV probability distribution with the sescenarios.You can assume a probability of 50% for the base NPV forecast ,a probability of 15% for the best-casescenario, and a probability of 35%for the worst-casescenario.