A manufacturing facility at a cost of $80MM. is looking for a smart investment d

Question

A manufacturing facility at a cost of $80MM. is looking for a smart investment decision to expand the company. Analysis has indicated there would be $16,000,000 in Operating cash inflows (savings) each year for the first 5 years.

Make a recommendation to as to whether they should proceed or not. Here are more information:

1. The company’s target capital strategy is 58% long-term debt, 17% Preferred and 25% common stock Equity

2. Tax rate is 28%

3. Equity – current share price is $40 and last year’s dividend was $2. Growth rate has been and is expected to stay at 5%.

a.Company’s risk (beta) has been rated at 0.65

b.The current market is returning 13% while the risk free rate has held steady at 8%

(Since we deliver a dividend, please AVERAGE the two costs to determine the AVERAGE cost of equity for our company)

4. Preferred stock – Fixed dividend of $2.21 and net proceeds from sale would be $28 per share

5. Long term debt – Our bonds are yielding a 9.5% rate

Explanation / Answer

Here we will use the concept of present value.

A project is acceptable only if it returns a positive net present value .If it returns a negative NPV ,it means that the present value of cash outflows exceed the present value of cash inflows.

If a project gives NPV=0 , the company will be indifferent as to whether accept or reject the proposal.

It means the net present value of cash inflows equals the net present value of cash outflows.

Given:

Cash outflow 80m

Cash inflow=16m for next 5 years

We will calculate weighted average cost of capital and discount the cash inflows by weighted average cost of capital.

Capital structure=58% long term debt + 17 % preferred +25% common stock

Weighted average cost of capital=Debt/Total capital * cost of debt   +   Common stock/Total capital * cost of equity + Preferred capital/Capital * cost of preferred stock

Cost of debt=interest rate * (1-tax rate)

Cost of debt K=9.5 % *(100-28)=6.65%

Cost of common stock

Cost of equity using CAPM method

Required rate of return or cost of equity=Risk free rate + beta (Market return-Risk free rate)

Cost of equity=.08 + .65 (.13-.08)

Cost of equity=11.25%

Cost of equity using dividend discount model

Value of stock=Next year’s dividend/(k-g)

K=Required rate of return

G=dividend growth rate

Last year’s dividend =$2

Dividend growth rate=5%

Next year dividend =Last year’s dividend * (1+ r)

Next year dividend=2 * (1+.05)

Next year dividend=2.1

Value of stock=2.1/ (k-.05)

40=2.1/ (k-.05)

K=10.25%

Cost of equity=10.25%

We will average the above two cost of equity

Ke = (11.25 +10.25)/2=10.75%

Cost of preferred equity

Kp =Dividend per annum/Market price per share

Kp=2.21/28=7.89%

WACC=58/100 * .0665 + 17/100 * .1075 + 25/100 * .0789

WACC=.03857 + .0019 +.01972=6.0195%

Now we will calculate the present value of ash inflows .

Present value of cash inflows =16m/(1+.060195)^1 + 16m/(1+.060195)^2 + 16m/(1+.060195)^3+ 16m/(1+.060195)^4+16m/(1+.060195)^5

NPV=Present value of cash inflows-Present value of cash outflow

NPV=67,362,082.43-80000000=-$12,637,917.57

Since NPV is negative ,it should not accept    the project.

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