Question: Your firm is considering undertaking a project which requires an initial cash outlay of $750,000 and a $20,000 increase in working capital. The product will sell for $50 per unit. Anticipated demand is 7,500 units for the first 2 years increasing to 10,000 units for the remaining 3 years of the project. Annual fixed costs are $50,000 and variable costs are 40% of sales. Interest expenses are $10,000 per year. Assume straight line depreciation and a 35% tax rate.
You intend to use retained earnings to finance this project; hence you will evaluate the project based on WACC. Your firm currently has a $25,000 par value bond issue outstanding (25, $1000 bonds) paying an 4% coupon rate, with 20 years remaining until maturity and semiannual payments. This is your only bond issue and it is currently selling for $980 per bond.
You have no preferred stock but you do have $2 million shares of common stock outstanding with a beta of .9. Current market conditions are such that the risk free rate is 2.5% and the S&P 500 is yielding a 10% return per annum. In order pursue this project the firm is retaining 40% of its earnings and just paid a $2 dividend per share.
Calculate the FCF of the project in each year and use this to calculate the IRR of the project.
What is your firm's cost of debt?
What is your firm's cost of equity?
What is the firm's capital structure?
What is your firm's WACC?
By using WACC as the discount rate, what assumptions are we making about this project?
At what interest rate are you indifferent between undertaking this project and not?
Should it be undertaken according to the NPV criteria?
Preform a scenario analysis based on a 20% variation in the dollar amount of variable cost.
Interpret this result.
Explain the purpose of a scenario analysis- how are the variation amounts decided?
Assume that after year 5 the firm will settle to a long term average growth rate of 5% per year. What is your best estimate of the stock price?
How does stock price compare to the estimate based on the growth rate of dividends using a 40% retention ratio? Why might this be the case?