Richland Merchants is analyzing a proposed expansion project that is riskier tha

Question

Richland Merchants is analyzing a proposed expansion project that is riskier than the firm's current operations. Due to the nature of the project, the firm has stated that the project will be assigned a discount rate equal to the firm's cost of capital plus 3.5 percent. The company wants to build a new distribution center on leased land at a cost of $16.5 million dollars that will be depreciated on a straight-line basis over 20 years. An additional $145,000 is required for developmental design plans and consulting fees. The center will require an increase in current assets of $1.3 million during the project's life. These assets will be recouped at the end of the project. Management estimates that the facility will generate sales of $3.1 million a year over its 20-year life. At the end of 20 years, the company plans to sell the facility for an estimated $20 million. The company has 70,000 shares of common stock outstanding at a market price of $43 a share. This stock just paid an annual dividend of $2.10 a share. The dividend is expected to increase by 3 percent annually. The firm also has 8,000 shares of 5 percent preferred stock with a market value of $62 a share. The preferred stock has a par value of $100. The company has a 7 percent, semiannual coupon bond issue outstanding with a total face value of $1.3 million. The bonds are currently priced at 99.5 percent of face value and mature in 13 years. The tax rate is 34 percent. Should Richland Merchants pursue the expansion at this point in time? Why or why not? Use NPV and IRR.

Explanation / Answer

PROJECT CASH FLOWS

The first point to note that depreciation being a non-cash expense, will not be considered for cash flow based decision making purposes.

Initial investment, year 0 = $16.5 million + $0.145 million + $1.3 million = $17.945 million

Annual Sales (Benefit) = $3.1 million

Terminal year cash inflow, Year 20 = Sales + Salvage value + Working capital recouped

= $(3.1 + 20 + 1.3) million = $24.4 million

PROJECT DISCOUNT RATE (WACC)

(a) Total capital structure = Equity + Debt + Preferred stock

= (70,000 x $43) + $1.3 million + (8,000 x $100)

= $3.01 million + $1.3 million + $0.8 milion

= $5.11 million

(b)

Proportion of equity = 3.01 / 5.11 = 58.9%

Proportion of debt = 1.3 / 5.11 = 25.44%

Proportion of preferred stock = 0.8 / 5.11 = 15.66%

(c) Cost of equity

ke = (Next year dividend / Current stock price) + dividend growth rate

= [$2.10 x 1.03 / $43] + 0.03 = 0.05 + 0.03 = 0.08

ke = 8%

(d) **

Cost of debt = Annual coupon payment x (1 - tax rate) / Market price of bond

= $1000 x 7% x (1 - 0.34) / $995

= 0.0464 = 4.64%

(e) **

Cost of preferred stock = Annual preferred dividend / Current Market Price

= $100 x 5% / $62 = 8.06%

** Calculated on market value basis

(f) Weighted average cost of capital

WACC = (58.9% x 8%) + (25.44% x 4.64%) + (15.66% x 8.06%)

= 4.71% + 11.8% + 1.26%

= 17.77%

(g) Project discount rate = WACC + 3.5%

= 13.77% + 3.5%

= 21.27%

CALCULATING NPV

Since NPV < 0, project should be rejected.

IRR

The project IRR using Excel =IRR() function is 17.41%, which is lower than the project's required rate of return (21.27%).

So, project should be rejected.

Year CF ($) Discount Factor@21.27% Discounted CF ($) 0 -17.945 1.0000 -17.95 1 3.1 0.8246 2.56 2 3.1 0.6800 2.11 3 3.1 0.5607 1.74 4 3.1 0.4624 1.43 5 3.1 0.3813 1.18 6 3.1 0.3144 0.97 7 3.1 0.2593 0.80 8 3.1 0.2138 0.66 9 3.1 0.1763 0.55 10 3.1 0.1454 0.45 11 3.1 0.1199 0.37 12 3.1 0.0988 0.31 13 3.1 0.0815 0.25 14 3.1 0.0672 0.21 15 3.1 0.0554 0.17 16 3.1 0.0457 0.14 17 3.1 0.0377 0.12 18 3.1 0.0311 0.10 19 3.1 0.0256 0.08 20 24.4 0.0211 0.52 IRR = 17.41% NPV = -3.23

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