Question

We are examining a new project, which is a scale expansion of our existing business, i.e. the nature of our new project is very similar to our existing business. We are a focused firm, operating in one industry. We expect to sell 6 million units per year at a price of $650 and a variable cost of $585. Annual fixed costs are expected to be $300 million. The project requires an initial investment of $200 million in equipment, to be depreciated on a straight-line basis over the 10 years. It also requires an investment of $100 million in working capital, which will be fully recovered at the end of the project. Our company’s equity beta is 1.2, and 30% of our capital structure is debt. However, we expect to finance the project with only 10% debt. The tax rate is 35%, the ten-year treasury bonds are yielding 4.1%, and the equity market risk premium is 7%. We expect to pay an interest rate of 5% on our debt. Assume the debt is riskless, i.e. ??" = 0.

a) The new project is a scale expansion. Why is this information relevant in order to evaluate the project? Discuss.

b) Imagine the project was significantly different from our existing business. Explain how you would obtain relevant variables for valuation

c) compute the WACC of the new project

Answer 1

a) This information is relevant to determine the risk adjusted discount rate.Since ,it is an expansion project , the risk level will be same as the existing risk. Hence the cost of capital can be used as discount factor without adjustment due to higher or lower risks

b)If it is significantly different from the existing business , the risk of the project needs to be evaluated . This risk evaluation can be carried out by additional market and economic information. The cost of capital of other companies in similar business can be analysed

c) WACC:

	Wd	Weight of Debt in the capital structure	0.1000
	We	Weight of Equity in the capital structure	0.9000
		Weighted Average Cost of Capital (WACC)
		WACC=Wd*Cd+We*Ce
		Wd=Weight of debt in the total capital
		We=Weight of Common Shares in the total capital
		Cd=Cost of debt
		Ce=Cost of Equity
		AFTER TAX COSTS:
		Before tax cost	5%
	Cd	After Tax Cost of debt=5.*(1-Tax Rate)=5.*(1-0.35)=	3.25%
		Common Equity:
		CAPM EQUATION:Rs=Required Return of stock
		Rs=Rf+Beta*(Rm-Rf)
		Rf=riskfree rate=4.1%, Rm-Rf=Market risk Premium=7%, Beta=1.2
		Rs=4.1+1.2*7=	12.50%
	Ce	Cost of Equity =	12.50%
		After Tax Weighted average Cost of Capital:
		WACC=Wd*Cd+We*Ce=	11.58%