Company: BubblePop Project: APPKiller You’re the CFO of the tech company, Bubble
ID: 2744427 • Letter: C
Question
Company: BubblePop Project: APPKiller You’re the CFO of the tech company, BubblePop. Your CMO (Chief Marketing Officer) is proposing a new product called APPKiller that will be sold online for $10 per unit. The CMO expects sales of 100,000, 110,000, 120,000, 90,000 and 70,000 units over the products 5 year life. COGS is 20% of sales and operating expenses are estimated at $350,000 per year. The company’s tax rate is 30%.
The initial investment in the project is as follows.
$1,000,000 for fixed equipment machinery
$200,000 in initial raw materials
The machinery is depreciated over 8 years straight-line ($125,000 per year).
At the end of 5 years, the product is expected to become obsolete. The machinery will be sold off for $600,000 at that time. Raw materials will be sold off netting the company the $200,000 back that they had originally invested.
FYI, the company has already spent $75k on an overpriced consultant last year analyzing this deal. (I heard he was a college professor in RI).
Oh, and about their WACC……
The company’s stock is trading for $20 per share. There are 50,000 shares outstanding. Company beta is 2.0. The market risk premium is 6% and the risk free rate of return is 3%.
Corporate debt matures in 2020 and is trading at 90% on 800 bonds with a par value of $1,000. The coupon rate is 10%. The bonds pay coupons semi-annually (2x per year).
The company has a small amount of Preferred stock. 2,000 shares trading at $90. Par value is $100 and annual income on the Preferred stock is 9.5%.
Using NPV, should the company invest in the APPKiller project?
Explanation / Answer
Initial Outflow = $1,000,000 + $200,000 + $75,000 = $1,275,000
Salvage Value of Machine = $600,000
Since the salvage value of machine is higher than the book value, there will be tax on the additional amount over book value.
After-tax Salvage Value = ($125,000 x 3) + {[$600,000 – ($125,000 x 3)] x (1-0.30)} = $532,500
Year
1
2
3
4
5
Sales
$1,000,000
$1,100,000
$1,200,000
$900,000
$700,000
Less: COGS
$200,000
$220,000
$240,000
$180,000
$140,000
Less: Operating Expense
$350,000
$350,000
$350,000
$350,000
$350,000
Less: Depreciation
$125,000
$125,000
$125,000
$125,000
$125,000
EBT
$325,000
$405,000
$485,000
$245,000
$85,000
Less: Tax @ 30%
$97,500
$121,500
$145,500
$73,500
$25,500
EAT
$227,500
$283,500
$339,500
$171,500
$59,500
Add: Depreciation
$125,000
$125,000
$125,000
$125,000
$125,000
Add: Salvage Value of Machine
$0
$0
$0
$0
$532,500
Add: Recovery of initial raw material
$0
$0
$0
$0
$200,000
Operating Cash Flow
$352,500
$408,500
$464,500
$296,500
$917,000
WACC Calculation:
Market Value of Equity = 50,000 x $20 = $1,000,000
Market Value of Bond = 90% x (800 x $1,000) = $720,000
Market Value of Preferred Equity = $90 x 2,000 = $180,000
Total Capital = $1,000,000 + $720,000 + $180,000 = $1,900,000
Weight of Equity = $1,000,000/$1,900,000 = 0.526315789
Weight of Bond = $720,000/$1,900,000 = 0.378947368
Weight of Preferred Equity = $180,000/$1,900,000 = 0.094736842
Cost of Equity: It is the required return as per CAPM model.
=> Rf + Beta*(Rm – Rf)
=> 3% + 2*(6%) =15%
Cost of debt: It is the after-tax YTM of the bond.
Bond Value = C/2 {[1-(1+(YTM/2))-2t/(YTM/2)] + [F / (1+ (YTM/2))2t]
B0 = $900 (90% of $1,000)
C = $1,000 x 10% = $100
F = $1,000
YTM = the yield to maturity on the bond
t = 4 Years
$900 = $100/2 {[1-(1+(YTM/2))-8/(YTM/2)] + [$1,000 / (1+ (YTM/2))8] = 13.3%
After-tax YTM = YTM x (1-tax rate) => 13.3% x (1-0.30) = 9.31%
Cost of preferred stock: It’s simply the coupon rate paid. => 9.5%
WACC = (0.526315789 x 0.133) + (0.378947368 x 0.0931) + (0.094736842 x 0.095) = 0.11428 or 11.428%
NPV = -$1,275,000 + [($352,500)/(1.11428)] + [($352,500)/(1.11428)2] + [($352,500)/(1.11428)3] + [($352,500)/(1.11428)4] + [($352,500)/(1.11428)5] = $432,246.77
Since the NPV is positivie, Company should invest in APPKiller Project.
Year
1
2
3
4
5
Sales
$1,000,000
$1,100,000
$1,200,000
$900,000
$700,000
Less: COGS
$200,000
$220,000
$240,000
$180,000
$140,000
Less: Operating Expense
$350,000
$350,000
$350,000
$350,000
$350,000
Less: Depreciation
$125,000
$125,000
$125,000
$125,000
$125,000
EBT
$325,000
$405,000
$485,000
$245,000
$85,000
Less: Tax @ 30%
$97,500
$121,500
$145,500
$73,500
$25,500
EAT
$227,500
$283,500
$339,500
$171,500
$59,500
Add: Depreciation
$125,000
$125,000
$125,000
$125,000
$125,000
Add: Salvage Value of Machine
$0
$0
$0
$0
$532,500
Add: Recovery of initial raw material
$0
$0
$0
$0
$200,000
Operating Cash Flow
$352,500
$408,500
$464,500
$296,500
$917,000
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