Question

Company C is considering a new project that is expected to last for 5 years. Its marketing group expects annual sales of $40 million for the first year, increasing by $10 million per year for the following four years. Manufacturing costs (i.e., COGS) and operating expenses (excluding depreciation) are expected to be 40% of sales and $7 million, respectively, from years 1-5. Developing the product will require upfront R&D and marketing expenses of $8 million total in period 0. The fixed assets necessary to produce the product will require an investment of $20 million in period 0. The equipment will be obsolete once production ceases and (for simplicity) will be depreciated via the straight-line method over the five year period for tax purposes. The company expects to incur a $1 million net working capital outlay at the start of the project (period 0) that is recovered at the end of the project (period 5). The company has a target of 60% equity financing (E/V=0.6), a cost of debt of 5%, a cost of equity of 12%, and pays a 35% corporate tax rate. The economy-wide risk-free rate is 4%. Calculate the Net Present Value of the project. Assume the project has the same riskiness as the overall firm. Please answer in millions of dollars (e.g., if the answer is one billion dollars enter 1,000 not 1,000,000,000).

6.9.1

Answer 1

WACC = (after tax cost of debt * weight of debt) + (cost of equity * weight of equity)

after tax cost of debt = before tax cost of debt * (1 - tax rate) = 5% * (1 - 35%) = 3.25%

WACC = (3.25% * 40%) + (12% * 60%) = 8.5%

Operating cash flow (OCF) each year = income after tax + depreciation

In year 5, the entire working capital investment is recovered.

NPV is calculated using NPV function in Excel

NPV is $56,962,726, or $56.97 million, or $57 million

NPV is $56,962,726, or $56.97 million, or $57 million