Question

NEWMAN ENTERPRISES, Inc. is a multinational conglomerate corporation providing a wide range of goods and services to its customers. As part of its budgeting process for the next year, it has three mutually exclusive projects under consideration, and it might decide which project should receive the investment funds for this year.

As part of the financial analysis team, it is up to you to determine the appropriate valuation of each project. However, before you can determine the appropriate valuations of these projects, you need to determine the weighted average cost of capital for the firm. Senior management has expressed to you a preference in using the market values of the firm’s capital structure and believes it current structure is optimal.

BALANCE SHEET

Cash	2,000,000	Accounts Payable and Accruals	18,000,000
Accounts Receivable	28,000,000	Notes Payable	40,000,000
Inventories	42,000,000	Long-Term Debt	60,000,000
		Preferred Stock	10,000,000
Net Fixed Assets	133,000,000	Common Equity	77,000,000
Total Assets	205,000,000	Total Claims	205,000,000

Market Values of Capital

The company has 60,000 bonds with a 30-year life outstanding, with 15 years until maturity. The bonds carry a 10 percent semi-annual coupon, and are currently selling for $874.78.

You also have 100,000 shares of $100 par, 9% dividend perpetual preferred stock outstanding. The current market price is $90.00. Any new issues of preferred stock would incur a $3.00 per share flotation cost.

The company has 5 million shares of common stock outstanding with a currently price of $14.00 per share. The stock exhibits a constant growth rate of 10 percent. The last dividend (D₀) was $.80. New stock could be sold with flotation costs, including market pressure, of 15 percent.

The risk-free rate is currently 6 percent, and the rate of return on the stock market as a whole is 14 percent. Your stock’s beta is 1.22.

Your firm does not use notes payable for long-term financing.

Your firm’s federal + state marginal tax rate is 40%.

Project A:

This project requires an initial investment of $20,000,000 in equipment which will cost an additional $3,000,000 to install. The firm will use the attached MACRS depreciation schedule to expense this equipment. Once the equipment is installed, the company will need to increase raw goods inventory by $5,000,000, but it will also see an increase in accounts payable for $1,500,000. With this investment, the project will last 6 years at which time the market value for the equipment will be $1,000,000.

The project will project a product with a sales price of $20.00 per unit and the variable cost per unit will be $10.00. It is estimated the sales volume for this project will be 700,000 in year 1, 1,000,000 in year 2, 650,000 in year 3, 700,000 in year 4, 650,000 in year 5 and 550,000 in year 6. The fixed costs would be $2,000,000 per year. Because this project is very close to current products sold by the business, management has expressed some favoritism towards this project and as allowed for a reduced rate of return of 2 percentage point below its current WACC as the valuation hurdle it must meet or surpass.

Project B:  

This project requires an initial investment of $20,000,000 in equipment which will require additional expense of $1,000,000 to install in the current facility. Consistent with other projects, the equipment will be depreciated using the MACRS Investment Class schedule. Once installed, the firm will need to increase inventory by $6,000,000. The project will last 6 years, but at the end of that period, the equipment will have no salvage value.

During the operational period of this project, the product produced will sell for $6.50 per unit. The costs related to this product will be $4.00 per unit in variable cost and the fixed costs each year will be $1,000,000. Management has estimated that the sales volume for this project will be 3,500,000 in year 1, 4,000,000 in year 2, 4,250,000 in year 3, 4,500,000 in year 4, 4,300,000 in year 5, and 4,200,000 in year 6. Since the project has been brought under consideration through the normal channels, a discount rate equal to the WACC should be used in the project valuation.

Project C:

The project is outside of the normal products sold of the firm. The project is a reconsideration of a project proposed two years ago by a former manager. At that time a marketing study costing $200,000 was done; however, the project was not undertaken. Now the firm needs to consider if this project is worth the firm’s capital investment dollars. This project would require investment in equipment of $20,000,000 with an additional cost of $5,000,000 in installation fees. The project will be considered under a 6 year project cycle, but would be depreciated under the 5 year MACRS schedule. At the end of the project, management estimates that the equipment could be sold at a market value of $5,000,000. This project also creates a need to increase raw goods inventory by $6,000,000.

During the operational cycle of this project, the product would have a sales price of $90.00 per unit. Costs associated with this project would be $65.00 in variable cost per unit and a fixed cost per year of $5,000,000. Management estimates that the sales volume would be 500,000 units in year 1, 600,000 units in year 2, 700,000 units in year 3, 800,000 units in year 4, 800,000 units in year 5, and 600,000 units in year 6. Because management is uneasy with undertaking a project so far outside of its normal product portfolio, it is imposing a 3 percentage point premium above the WACC as the required rate of return on the project.

Modified Accelerated Cost Recovery System (MACRS)
Ownership Year		5-Year Investment Class Depreciation Schedule
1		20%
2		32%
3		19%
4		12%
5		11%
6		6%
		Total = 100%

2. Determine the target percentages for the optimal capital structure, and then compute the WACC. (Carry weights to four decimal places. For example: 0.2973 or 29.73%)

Answer 1

Step 1: Calculate Weights (Target Percentages for Optimal Capital Structure)

The weights of different sources of finance are calculated as below:

Market Value of Debt (Bonds) = Number of Bonds*Current Selling Price = 60,000*874.78 = $52,486,800

Market Value of Preferred Stock = Number of Preferred Shares*Current Market Price = 100,000*90 = $9,000,000

Market Value of Equity = Number of Common Shares*Current Share Price = 5,000,000*14 = $70,000,000

Total Market Value = 52,486,800 + 9,000,000 + 70,000,000 = $131,486,800

Now, we can calculate the weights as follows:

Weight of Debt = Market Value of Debt/Total Market Value*100 = 52,486,800/131,486,800*100 = 39.92%

Weight of Preferred Stock = Market Value of Preferred Stock/Total Market Value*100 = 9,000,000/131,486,800*100 = 6.84%

Weight of Equity = Market Value of Equity/Total Market Value*100 = 70,000,000/131,486,800*100 = 53.24%

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Step 2: Calculate After-Tax Cost of Debt

The cost of debt can be calculated with the use of Rate function/formula of EXCEL/Financial Calculator. The function/formula for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Payment (here, Coupon Payment), PV = Present Value (here, Current Selling Price) and FV = Future Value (here, Face Value of Bonds).

Here, Nper = 15*2 = 30 (as the remaining period is 15 years), PMT = 1,000*10%*1/2 = $50, PV = $874.78 and FV = $1,000 [we use 2 since the bond is semi-annual]

Using these values in the above function/formula for Rate, we get,

Pre-Tax Cost of Debt = Rate(30,50,-874.78,1000)*2 = 11.80%

After-Tax Cost of Debt = Pre-Tax Cost of Debt*(1-Tax Rate) = 11.80%*(1-40%) = 7.08%

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Step 3: Calculate Cost of Preferred Stock

The cost of preferred stock is determined as below:

Cost of Preferred Stock = Annual Dividend/(Current Stock Price - Flotation Cost) = (100*9%)/(90 - 3)*100 = 10.34%

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Step 4: Calculate Cost of Equity

We will have to calculate the cost of equity under CAPM and DCF and take the average of two to arrive at the cost of equity:

Cost of Equity (CAPM) = Risk Free Rate + Beta*(Market Return - Risk Free Rate) = 6% + 1.22*(14% - 6%) = 15.76%

Cost of Equity (DCF) = Current Dividend/(Current Selling Price - Flotation Cost) + Growth Rate = .80*(1+10%)/(14 - 15%*14) + 10% = 17.39%

Cost of Equity (Average) = [Cost of Equity (CAPM) + Cost of Equity (DCF)]/2 = (15.76% + 17.39%)/2 = 16.58%

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Step 5: Calculate WACC

The WACC can be calculated with the use of following formula:

WACC = Weight of Debt*After-Tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Equity*Cost of Equity (Average) = 39.92%*7.08% + 6.84%*10.34% + 53.24%*16.58% = 12.36%