Question

Carolyn Nesbitt, the CEO of Macrocorp, is considering a project to expand the existing business into a new product line that involves considerable up-front investments in new equipment as well as an initial investment in net operating working capital. Her executives’ cash flow projections are fairly aggressive with $500 M in sales at the end of the first year increasing by 5% annually for the next five years. Cost of goods sold is expected to be $250M in the first year, increasing by 6% annually for the next five years. The initial equipment costs $1,500M and its salvage value in five years is $750 M. Annual depreciation is calculated using the straight-line method (e.g. an equal amount each year based on the salvage value in five years). The initial investment in net operating working capital is $300M, which Carolyn thinks she can redeploy elsewhere in the firm after five years. After five years, it is expected that the technology will be obsolete. Carolyn expects to pay taxes at a corporate rate of 25%.

Carolyn is considering whether to take on the project, as well as how to finance it. Her chief financial officer is proposing to borrow $800 M to finance the equipment and investment in net operating working capital. If the firm borrows to finance the project, its leverage ratio (defined as the ratio of total debt to total assets) would be approximately 53%. The current cost of debt for a five-year bond with principal repayment in five years is 6%.

Were the firm to finance the project entirely with equity, the expected return to its investors would be 7.5%.

Part A

What is the net present value of the project if it is all equity financed? Should Carolyn take on the project under this financing scenario? Explain why.

Part B

Suppose now that Carolyn adopts her CFO’s plan to finance the project with $800M in debt. Calculate the NPV of the project using the APV method. Should Carolyn take on the project? Explain why.

Part C

Calculate the NPV of the project using the WACC method, assuming that CFO’s plan to finance with debt is adopted.

Part D

Calculate the NPV of the project using the FTE method, assuming that the CFO’s plan to finance with debt is adopted.

Answer 1

Operating cash flow
		Year 1	2	3	4	5	6
Sales		500	525	551.25	578.8125	607.7531	638.1408
Less: COGS		-250	-265	-280.9	-297.754	-315.619	-334.556
Less: Depn.		-150	-150	-150	-150	-150
EBIT		100	110	120.35	131.0585	142.1339	303.5844
Tax at 25%		-25	-27.5	-30.0875	-32.7646	-35.5335	-75.8961
EAT		75	82.5	90.2625	98.29387	106.6004	227.6883
Add back Depn.		150	150	150	150	150	0
Operating cash flow		225	232.5	240.2625	248.2939	256.6004	227.6883
NPV calculations fro full EQUITY funding
Initial equipment	-1500
NWC introd.& recovered	-300						300
After-tax salvage(750*(1-25%)							562.5
Operating cash flow		225	232.5	240.2625	248.2939	256.6004	227.6883
Net annual cash flows	-1800	225	232.5	240.2625	248.2939	256.6004	1090.188
PART A (Full equity)
PV F at 7.5%(Reqd.return )	1	0.93023	0.86533	0.80496	0.74880	0.69656	0.64796
PV at 7.5%	-1800	209.3023	201.1898	193.4018	185.9226	178.7372	706.4001
NPV for full equity funding	-125.046
Carolyn should not take on the project under this full-equity financing scenario as it returns NEGATIVE NPV
PART B (53% debt;47% equity)
PVof interest tax shields on $ 800 debt discounted at after-tax cost(6%*(1-25%)= 4.5%--of debt
ie. 800*6%*25%*4.38998=	52.680
(PVOA F 4.5%, 5 yrs.)
Adjusted PV =
-125.046+52.68=
-72.37
Carolyn should not take on the project under this 53%debt & 47% equity financing scenario also as it returns NEGATIVE NPV
PART C (NPV using WACC)
WACC=( 47%*7.5%)+(53%*6%*(1-25%))
5.91%
Discounting the after-tax cash flows at the WACC of 5.91%
Net annual cash flows	-1800	225	232.5	240.2625	248.2939	256.6004	1090.188
PV F at 5.91%(WACC )	1	0.94420	0.89151	0.84176	0.79479	0.75044	0.70856
PV at 5.91%	-1800	212.4445	207.276	202.2437	197.3414	192.5629	772.4666
NPV at WACC	-15.6649
NPV at WACC is NEGATIVE
PART D (FTE Method)
Net annual cash flows	-1800	225	232.5	240.2625	248.2939	256.6004	1090.188
Less:
After-tax interest expense		-36	-36	-36	-36	-36	-36
Free cash flow to Equity	-1800	189	196.5	204.2625	212.2939	220.6004	1054.188
PV F at 7.5%(Reqd.return )	1	0.93023	0.86533	0.80496	0.74880	0.69656	0.64796
PV at 7.5%	-1800	175.814	170.0379	164.4233	158.9658	153.6611	683.0734
NPV (FTE method)	-294.025
NPV as per FTE is NEGATIVE