Labs Inc. has an equity beta of 2 under capital structure (D/E) = 1. The current cost of debt for the firm is 7.5%. The projected firm's unlevered free cash flows in 2018 and 2019 are $111 million and 120 million, respectively. After 2019 cash flows are expected to increase 2% every year. Labs Inc. is considering investing in a new business in a different industry. The new project has a publicly traded competitor that is fully equity financed. Its equity beta is 3. The management of Labs Inc. is planning to use a D/V ratio of 0.4 for the new project. The borrowing rate is expected to be 6% for this project. The initial cost of the project is $150 million today. The new project is expected to produce sales revenue of $40 million in 2018 and this is expected to grow 3% every year. However, to sustain this sales level, they will have to make an investment of $3 million in PP&E in year 1 and this amount is expected to grow every year by 2%. Assume that (i) depreciation tax shields during all future years will equal to the investment in PP&E and (ii) there is no investment in NWC. According to forecasts, the cost of goods sold (excluding depreciation but including selling and general expenses) will be 40% of sales levels in each year.
Tax rate 40%
Yield on short term US T-bills 1%
Yield on long term US government bonds 4.0%
Risk premium (Rm-T-bills) 8.0%
Risk premium (Rm- gov. bonds) 6.75%
QUESTIONS:
1. Calculate the weighted average cost of capital for Labs Inc. at its current capital structure before the investment.
2. Assuming that the capital structure remains constant in the future if the new investment does not take place, what is the value of Labs Inc.’s equity prior to the new investment?
3. Prepare a financial statement to determine the unlevered free cash flows of the new project.
4. What would be the recommendation regarding the new business, if one uses Lab Inc.’s WACC to discount the cash flows of the new project? Is there anything conceptually wrong with this approach?
5. What is your analysis and make recommendation regarding the new business?