Question

Atlantic Glass Company makes custom, luxury shower door glass enclosures for new construction homes and bathroom remodeling projects. Recently they have received a significant number of inquiries from home builders and contractors about a new glass door design that includes both glass and iron in the shower enclosure materials.

Atlantic Glass’s current production facilities do not have the machinery or space to produce such a specialty, multi material enclosure so the company has turned down these potential orders. The sales department is frustrated by this and tells the CEO that this new product is in high demand and that it could be a significant source of growth for the company. The CEO agrees, and as a next step, launches two initiatives:

1. A customer research study to measure the potential size of the market for this specialty product within Atlantic’s addressable market geography. For this study, Atlantic will need to hire an outside consulting firm and pay them $500,000

2. A capital budgeting analysis to evaluate the potential investment merits (if any) of manufacturing and selling this specialty product line for the next 5 years.

The consulting firm’s findings confirm the sales department’s instincts. It is estimated that, at a selling price of $9,995 per unit, the company could sell 1,500 units in year one of production and that unit volume would grow by 10.0% per year in years 2-5. However, it is also estimated that the new enclosures would cannibalize existing product sales and result in $2 million of erosion costs per year on a pre-tax basis.

The manufacturing department estimates that, in order to produce the specialty enclosures, a $10 million investment in new fixed assets would be required to expand production capacity and capabilities. These fixed assets would be depreciated on a straight line basis over the 5 year estimated life of the project. The salvage value of these fixed assets is estimated to be $3 million at the termination of the project. It is also estimated that the shower enclosures could be produced at a variable cost per unit of $5,000.

Fixed SG&A expenses for the project are expected to be $3.2 million per year. It is also expected that the project will require operating capital investments in years 1-5 equal to 3.0% of product revenue. Atlantic expects to recoup all of its operating capital investment at the termination of the project.

Atlantic currently has a stock price of $22.50 per share and 18.4 million shares of common stock outstanding. The firm has a $50 million term loan outstanding at an interest rate of 4.25% and $200 million in outstanding senior bonds at a 6.50% interest rate. Current risk free rates are 2.40% and the expected equity market risk premium is 6.00%. Atlantic has a beta of 1.83. The company has a 30.00% tax rate.

Part 1. Using an excel spreadsheet, please build a 5 year incremental cash flow projection for the contemplated shower enclosure project. Based on the projections please determine the following.

1. What is the project’s expected NPV?
2. What is the project’s expected IRR?
3. What is the project’s expected payback period?
4. What is the project’s expected profitability index? (2 decimal places)

Part 2. Assuming the project has no working capital requirements and that the salvage value of assets is zero, what is the annual sales unit quantity required to break-even on a financial/NPV basis?

Answer 1

First we need to calculate weighted average cost of capital
- Cost of Equity
= Risk free rate + Beta(Expected market risk premium)
= 2.40% + 1.83(6.00%)
13.38%
Cost of Term Loan = 4.25%
Cost of Bonds = 6.50%
Capital Structure
Particulars	Amount	Weight	Cost	WACC
Equity	414	0.62	13.38%	8.34%
Term Loan	50	0.08	4.25%	0.32%
Bonds	200	0.30	6.50%	1.96%
	664			10.62%
So, Cost of capital will be considered at 10.62%
Year	Unit Sales	Sale price	Variable Cost Per Unit	Sales	VC
	A	B	C	D (A*B)	E (A*C)
1	1,500	9,995	5,000	1,49,92,500	75,00,000
2	1,650	9,995	5,000	1,64,91,750	82,50,000
3	1,815	9,995	5,000	1,81,40,925	90,75,000
4	1,997	9,995	5,000	1,99,55,018	99,82,500
5	2,196	9,995	5,000	2,19,50,519	1,09,80,750
Year	Opportunity Cost	SG&A Expense	Depreciation	PBT	Tax
	F	G	H ((100-3)/5)	I	J (I*30%)
1	20,00,000	32,00,000	19	54,92,481	16,47,744
2	20,00,000	32,00,000	19	62,41,731	18,72,519
3	20,00,000	32,00,000	19	70,65,906	21,19,772
4	20,00,000	32,00,000	19	79,72,498	23,91,749
5	20,00,000	32,00,000	19	89,69,750	26,90,925
Year	PAT	Operating Capital Requirement	Operating Capital Withdrawal	Net Cash Flow	PV Factor	PV of Cash Flow	Cumulative
	K	L	M	N(K+H-L+M)	O	P
1	38,44,736	4,49,775	-	33,94,981	1	30,69,042	30,69,042
2	43,69,211	44,978	-	43,24,253	1	35,33,802	66,02,844
3	49,46,134	49,475	-	48,96,678	1	36,17,413	1,02,20,257
4	55,80,749	54,423	-	55,26,345	1	36,90,626	1,39,10,883
5	62,78,825	59,865	6,58,516	68,77,495	1	41,52,005	1,80,62,888
					Total	1,80,62,888
So, Projects NPV is :
Total Net present value of cash flow			1,80,62,888
Less: Initial Investment			1,00,00,000
		NPV	80,62,888
IRR:
Year	Net Cash Flow	PV Cash Flow
0	-1,00,00,000	-1,00,00,000
1	33,94,981	30,69,042
2	43,24,253	35,33,802
3	48,96,678	36,17,413
4	55,26,345	36,90,626
5	68,77,495	41,52,005
IRR	35%	22%
Project expected Pay back as follows:
= 2 years + (3397156.31/10220256.78)
= 2.33 years
Project expeted profitability index is Present value of Cash flow/Initial Investment
i.e. 18062888/10000000 which is 1.81