Question

You have been hired as a financial analyst for Relentless Enterprises Inc. (REI), a large, publicly traded firm that is the market share leader in high-end smart home devices (SHDs). The company is looking to set up a manufacturing plant overseas to produce a new line of SHDs. The will be a five-year project. The company bought some land three years ago for $7.9 million in the anticipation of using it as a toxic dumpsite for chemicals, but it built a piping system to safely discard the chemicals instead. The land was appraised last week for $8.4 million on an after-tax basis. In five years the after-tax value of the land will be estimated at $9.1 million, but the company expects to keep the land for a future project. The company wants to build the new manufacturing plant on this land. The plant will cost $41 million to build. The following market data on REI’s securities are current:

Debt: 225,000 6.7% coupon bonds outstanding, 25 years to maturity, selling for 103 percent of par; the bonds have a $1,000 par value each and make semiannual payments.

Common stock: 9,400,000 shares outstanding, selling for $71 per share. The beta is 1.3

Preferred stock: 475,000 shares of 4.3% preferred stock outstanding, selling for $84 per share

Market rates: Market risk premium = 6%; risk free rate = 2%

REI uses Pacific Securities as its lead underwriter. Pacific charges REI spreads of 5% on new common stock issues, 4% on new preferred share issues, and 3% on new debt issues. Pacific has included all direct and indirect costs (along with its profit) in setting these spreads. Pacific has recommended to REI that it raise the funds needed to build the plant by issuing new shares of common stock. REI’s tax rate is 35%. The project requires $1,450,000 in initial net working capital investment to get operational. Assume Pacific raises all equity for new projects externally.

Required:

(a)          Calculate the project’s initial Time 0 cash flow, taking into account all factors and side effects.

(b)          The new SHD project is somewhat riskier than a typical project for REI, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +8% to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating REI’s project.

(c)           The manufacturing plant belongs to a CCA class 43 (30%). At the end of the project (that is, the end of year five), the plant can be scrapped for $6.1 million. What is the PVCCATS of this plant and equipment?

(d)          The company will incur $7,900,000 in annual fixed costs. The plan it to manufacture 18,900 SHDs per year and sell them for $13,450 per unit. The variable production costs are $9,500 per SHD. What is the operating cash flow (OCF) from this project?

Answer 1

a)

Cost of plant = $41 million

Initial net working capital = $1.45 million

Total investment = 41 + 1.45 = $42.45 million

Since the project will be funded by issuing common stock, the entire 42.45 million will be raised by issuing common stock

Cost of issuing common stock = 5% x 42.45 = $2.125million

Total cashflow = -(42.45 + 2.125) = -$44.575 million (negative sign as it is an outflow)

b)

FV of bond = 1,000

PV of bond = 1,000 x 1.03 = 1,030

Coupon 'C' = 6.7% x 1,000 = 67

Years to maturity n = 25

PV = C x [1 - (1 + YTM)^-n] / YTM + FV / (1 + YTM)

Substituting the values and using trial and error method, yield to maturity = 6.455%

Cost of debt = 6.455%

Market value of debt = number of bonds x market value of bond = 225,000 x 1030 = 231.75 million

Cost of preferred share = dividend / market price = 4.3 / 84 = 5.119%

Value of preferred shares = 475,000 x 84 = 39.9 million

Cost of common equity = riskfree rate + beta x market risk premium = 2 + 1.3 x 6 = 9.8%

Value of common share = value of common shares outstanding + value of common shares issued = 9,400,000 x 71 + 42.45 = 709.85 million

Total value of common shares, preferred shares and debt = 709.85 + 39.9 + 231.75 = 981.5 million

WACC = cost of debt x weight of debt x (1 - tax rate) + cost of preferred shares x weight of preferred shares + cost of common equity x weight of common equity

WACC = 6.455% x (231.75/981.5) x (1 - 0.35) + 5.119% x (39.9 / 981.5) + 9.8% x (709.85/981.5) = 8.286%

Adding 8% for the riskiness, the appropriate discount rate = 8.286 + 8 = 16.286%

c.

Year	1	2	3	4	5
Book Value of Plant for depreciation	20.500	34.850	24.395	17.077	11.954
Depreciation	6.150	10.455	7.319	5.123	3.586
Tax shield	2.153	3.659	2.561	1.793	1.255
PV of tax shield	1.851	2.706	1.629	0.981	0.590

Book value used for depreciation in year 1 will be half the initial value. Tax shield is tax rate x depreciation. Tax shield is discounted using 16.286% as discount rate. Next years book value will be current year book value - depreciation. Sum of PV of tax shield due to depreciation = 7.757million

Tax shield due to salvage value = (book value - salvage value) x tax rate = (31.449 - 6.1) x 0.35 = 8.872

Total PV of tax shield = 7.757 + 8.872 = 16.63 million

d.

	1	2	3	4	5
Revenue	$       235,305,000	$       235,305,000	$       235,305,000	$       235,305,000	$       235,305,000
Annual Fixed costs	$              790,000	$              790,000	$              790,000	$              790,000	$              790,000
Variable Costs	$       179,550,000	$       179,550,000	$       179,550,000	$       179,550,000	$       179,550,000
Depreciation	$           6,150,000	$         10,455,000	$           7,318,500	$           5,122,950	$           3,586,065
Earnings before tax	$         48,815,000	$         44,510,000	$         47,646,500	$         49,842,050	$         51,378,935
Tax	$         17,085,250	$         15,578,500	$         16,676,275	$         17,444,718	$         17,982,627
Net Income	$         31,729,750	$         28,931,500	$         30,970,225	$         32,397,333	$         33,396,308
Operating Cashflow	$         37,879,750	$         39,386,500	$         38,288,725	$         37,520,283	$         36,982,373

Operating cashflow = net income + depreciation

Revenue = 18,900 x $13,450 = $235,305,000

Variable costs = 18,900 x 9500 = $179,550,000