Question

Please answer all the 3 questions

Nanovo, Inc., is a manufacturer of low-cost micro batteries for use in a wide variety of compact electronic devices such as children's devices such as children's toys, wireless transmitters, and sensors. The growth in the use of these devices has steadily increased, leading to an ever greater demand for Nanovo’s products. Nanovo has responded to this increase in demand by expanding its production capacity, more than doubling the firm’s size over the last decade. Despite this growth, however, Nanovo does not have sufficient capacity to meet the current demand for its ultra-long-life, low-voltage batteries. You have been asked to evaluate two proposals to expand one of Nanovo’s existing plants, and make a recommendation.

Proposal 1 The Current Plant has a capacity of 25,000 cases per month. The first proposal is for a major expansion that would double the plant’s current capacity to 50,000 cases per month. After talking with the firm’s design engineers, sales managers, and plant operators, you have prepared the following estimates:

1. Expanding the plant will require the purchase of 3.6 million in new equipment, and entail upfront design and engineering expenses of 3.9 million. These costs will be paid immediately when the expansion begins.

2. Installing the new equipment and redesigning the plant to accomodate the higher capacity will require shutting down the plant for nine months. During that time, the plant’s production will cease. After the expansion is finished, the plant will operate at double it’s original capacity.

3. Marketing and selling the additional volume will lead to 1 million per year in additional sales, marketing, and administrative costs. These costs will begin in the first year while the plant is shut down.

Proposal 2 The engineers have also put forth a second proposal for a minor expansion that will increase the firm’s capacity by only 50% to 37,500 cases per month. While the capacity is smaller, such an expansion would be cheaper and less disruptive:

1. The smaller expansion will only require 2.4 million in new equipment, and 1.5 million in design and engineering expenses.

2. The existing plant will only need to be shut down for four months.

3. Sales, maketing and administrative costs will only increase by $500,000.

Nanovo believes that with or without any expansion, the technology used at the plant will be obsolete after six years and will have no salvage value, and the plant itself will need to be completely overhauled at that time. You also have the following additional general information: With or without eithe proposed expansion, Nanova will be able to sell all it can produce at an average wholesale price of $80 per case. The price is not expected to change during the next six years.

Nanovo has a gross profit margin of 55% on these batteries, Nanovo’s average net working capital at the end of each year will be equal 15% of it’s annual revenue. Nanovo pays a 40% corporate tax rate. Whole all design and engineering costs are immediately deductible as operating expenses, all capital expenditures will be straight-line depreciated for tax purposes over the subsequent six years. Management believes the risk of the expansion is similar to the risk of Nanovo’s existing projects, and because Nanovo is all equity financed, the risk of the expansion is also similar to the risk of Nanovo’s stock. You have the following additional information about the stock: Nanovo has no debt and has 2 million shares outstanding. The firm’s current share price is 75$ per share. Analysts are expecting Nanovo to pay a $3 divident at the end of this year, and to raise it’s divident at an average rate of 8% per year in the future.

1. Determine the annual incremental free cash flow associated with each expansion plan relative to the status quo (no expansion).

2. Compute the IRR and payback period of each expansion plan. Which plan has a higher IRR? Which has a shorter payback period?

3. Estimate Nanovo’s equity cost of capital. Use it to determine the NPV associated with each expansion plan. Which plan has a higher NPV?

Answer 1

Annual Net working capital required--- Proposal 1
	Year 0	Year 1	2	3	4	5	6
Annual sales(50000*12*80)		12000000	48000000	48000000	48000000	48000000	48000000
Sales cannibalised(25000*80*9)		-18000000
Net annual sales		-6000000	48000000	48000000	48000000	48000000	48000000
Net working capital reqd.(15%*Net sales)			7200000	7200000	7200000	7200000	7200000

Original (status-quo position)-- cash flows:
Sales revenues(25000*80*12)		24000000	24000000	24000000	24000000	24000000	24000000
NWC introduced & recovered ---1		-3600000					3600000
After-tax opg. Cash flows(24000000*55%*(1-40%)---2		7920000	7920000	7920000	7920000	7920000	7920000
Net annual cash flows(status Quo)---1+2		4320000	7920000	7920000	7920000	7920000	11520000

Expansion Proposal 1
	Year 0	Year 1	2	3	4	5	6
Initial equipment	-3600000
NWC introduced		0	-720000	0	0	0	0
NWC recovered							7200000
CAPEX & NWC-----1	-3600000	0	-720000	0	0	0	7200000
After-tax Upfront deisgn &engg. Expenses(3900000*(1-40%)-----2	-2340000
Gross profit(expansion)($80*55%*50000*12)		6600000	26400000	26400000	26400000	26400000	26400000
Less: Depreciation		-600000	-600000	-600000	-600000	-600000	-600000
Less: Mkg.& selling expense		-1000000	-1000000	-1000000	-1000000	-1000000	-1000000
EBT		5000000	24800000	24800000	24800000	24800000	24800000
Less: Tax at 40%		-2000000	-9920000	-9920000	-9920000	-9920000	-9920000
EAT		3000000	14880000	14880000	14880000	14880000	14880000
Add back depn.		600000	600000	600000	600000	600000	600000
Cash flow from operations------3		3600000	15480000	15480000	15480000	15480000	15480000
After-tax revenue lost due to shut-down for 9 mths.(80*55%*9*25000)------4		-5940000
Net annual cash flows(1+2+3+4)	-5940000	-2340000	14760000	15480000	15480000	15480000	22680000
Net annual cash flows(status Quo)---1+2		4320000	7920000	7920000	7920000	7920000	11520000
Incremental cash flows(of expansion 1 relative to status quo)	-5940000	-6660000	6840000	7560000	7560000	7560000	11160000

Annual Net working capital required--- Proposal 2
	Year 0	Year 1	2	3	4	5	6
Annual sales(37500*12*80)		24000000	36000000	36000000	36000000	36000000	36000000
Sales cannibalised(25000*80*4)		-8000000
Net annual sales		16000000	36000000	36000000	36000000	36000000	36000000
Net working capital reqd.(15%*Net sales)		2400000	5400000	5400000	5400000	5400000	5400000
NWC introd. & recovered		-2400000	-3000000				5400000

Expansion Proposal 2
	Year 0	Year 1	2	3	4	5	6
Initial equipment	-2400000
NWC introduced		-2400000	-3000000	0	0	0	0
NWC recovered							5400000
CAPEX & NWC-----1	-2400000	-2400000	-3000000	0	0	0	5400000
After-tax Upfront deisgn &engg. Expenses(1500000*(1-40%)-----2	-900000
Gross profit(expansion)($80*55%*37500*12)		13200000	19800000	19800000	19800000	19800000	19800000
Less: Depreciation		-400000	-400000	-400000	-400000	-400000	-400000
Less: Mkg.& selling expense		-500000	-500000	-500000	-500000	-500000	-500000
EBT		12300000	18900000	18900000	18900000	18900000	18900000
Less: Tax at 40%		-4920000	-7560000	-7560000	-7560000	-7560000	-7560000
EAT		7380000	11340000	11340000	11340000	11340000	11340000
Add back depn.		400000	400000	400000	400000	400000	400000
Cash flow from operations------3		7780000	11740000	11740000	11740000	11740000	11740000
After-tax revenue lost due to shut-down for 4 mths.(80*55%*4*25000*(1-40%))------4		-2640000
Net annual cash flows(1+2+3+4)	-3300000	2740000	8740000	11740000	11740000	11740000	17140000
Net annual cash flows(status Quo)---1+2		4320000	7920000	7920000	7920000	7920000	11520000
Incremental cash flows(of expansion 2 relative to status quo)	-3300000	-1580000	820000	3820000	3820000	3820000	5620000

2….
Incremental cash flows(of expansion 1 relative to status quo)	-5940000	-6660000	6840000	7560000	7560000	7560000	11160000
IRR of the Incremental cash flows	42%
Payback
Cumulative cash flows	-5940000	-12600000	-5760000	1800000	9360000	16920000	28080000
Pay back period=2+(5760000/7560000)=	2.76	Years
Incremental cash flows(of expansion 2 relative to status quo)	-3300000	-1580000	820000	3820000	3820000	3820000	5620000
IRR of the Incremental cash flows	39%
Payback
Cumulative cash flows	-3300000	-4880000	-4060000	-240000	3580000	7400000	13020000
Pay back period=3+(240000/3820000)=	3.06	Years
Proposal 1 has higher incremental IRR
Proposal 1 has shorter pay-back period of incremental cash flows

3… To find ----Cost of Equity

Using the formula

P(0)=D1/(r-g)

Where   P(0)=current share price= $ 75 ; D1= D0(1+g)

r= cost of equity to be found out & g= growth rate= 8%

75=3*(1.08)/(r-8%)

Cost of equity ,r= 12.32%

3..
Incremental cash flows(of expansion 1 relative to status quo)	-5940000	-6660000	6840000	7560000	7560000	7560000	11160000
PV F at 12.32% Ke	1	0.89031	0.79266	0.70571	0.62831	0.55939	0.49803
PV at 12.32%	-5940000	-5929487	5421780	5335198	4749998	4228987	5558039
Incremental NPV	13424515
Incremental cash flows(of expansion 2 relative to status quo)	-3300000	-1580000	820000	3820000	3820000	3820000	5620000
PV F at 12.32% Ke	1	0.89031	0.79266	0.70571	0.62831	0.55939	0.49803
PV at 12.32%	-3300000	-1406695	649979.5	2695827	2400131	2136869	2798941
Incremental NPV	5975053
Proposal 1 has higher incremental NPV