Question

Fanning Analytics manufactures a variety of electronic products. The company is considering introducing its most exciting product; a new digital instrument panel for customized classic cars. This panel allows the car owner to customize the complete set of instruments for the vehicle. Output display may be analog or digital, with many styles of display using apps that may be purchased, downloaded, and installed with a micro SD card. Market studies indicate that the “Fully Customizable Instrument Panel” (FCIP) may be valuable to any vehicle owner that wants to customize their car and add another layer of diagnostic information at their fingertips, and especially to an enthusiast. The company analyst interns have also provided the following forecasts for the project.

·The company will have to purchase a new machine to produce the new product. The equipment, including shipping and installation is expected to cost (t=0) $ 5,275,000.

·If the company goes ahead with the proposed product, it will have an effect on the company’s net operating working capital. At the outset, t = 0, inventory will increase by $235,000. Accounts payable will increase by $50,000 and accounts receivable will increase by $40,000.

·The net operating working capital will be liquidated after the project is completed.

·The program (project) is planned to continue for 9years. At the end of the project the equipment will be salvaged (sold). The forecasts predict that the equipment can be sold then for $95,000.

·The equipment falls into the IRS 5-year class life using the MACRS depreciation method with the ½ year convention. The IRS depreciation table is:

Year   Depreciation

(% of depreciable basis)

1       20.00%

2       32.00%

3       19.20%

4       11.52%

5       11.52%

6       5.76%

·Sales Forecast:

The estimates of sales revenues for this project are:

O Year 1: 1,250,000

O Year 2: 2,875,000

O Year 3: 3,450,000

O Sales are expected to continue to grow in years 4, 5, and 6 by 10% per year.

O Sales are then expected to decline by 15% per year in years 7, 8, and 9.

·Production cost forecasts are:

O Fixed costs: $234,000 per year.

O Annual variable costs: 51% of revenue.

·The company has a marginal (federal + state) tax rate (T) of 34%.

·Your analysts compiled current market information:

O Market risk premium (rm–rrf):4.25%

O Risk-free rate (rrf):1.82%

·The company’s beta (at its current capital structure) is:1.37

·Current Capital Structure

Fanning has the following levels of debt and common equity (market values):

O Debt:      $2,450,000

O Equity:   $7,350,000

O Total Capital: $9,800,000

·Fanning Analytics uses the firm’s WACC for average risk projects, it adds 2% for high risk projects. For low risk projects it uses the WACC less 2%.

·Management utilizes risk adjusted hurdle rates for evaluating capital budgeting projects.

All potential projects are classified using a five level classification system:

Risk Level             Class                              Hurdle Rate

A                           Low risk                          WACC –2

B                           Below average risk          WACC –1

C                          Normal risk                     Equal to the WACC

D                          Above average risk          WACC + 1

E                           High risk                         WACC + 2

·Fanning Analytics considers this to be a high risk project.

·After discussions with an investment banker about issuing additional debt, your analyst found that the cost of debt (before tax) depends on the amount of debt in the capital structure. Fanning Analytics’ cost of debt estimates for various levels of debt financing (D/E) were obtained and the firm’s analysts have partially prepared information for the company’s cost of capital at various levels of debt and equity:

Capital Structure Worksheet

Capital Structure Worksheet
	D/A				E/A
D/E	(Wd)	rd	rd(1-T)	b	(Wce)	rs	WACC
0	0.000	0.00%	0.00%	1.12	1.000	6.59%	6.593%
0.33	0.250	5.12%	3.38%	1.37	0.750	7.64%
	0.333	5.25%		1.49	0.667		6.600%
0.75		6.75%	4.46%		0.571	8.95%	7.026%

·Where:

O rd= before tax cost of debt,

O rd(1-T) = after tax cost of debt,

O b = beta,

O rs= cost of common equity,

O Wd= Weight of debt,

O Wce= Weight of common equity,

Given all of the information provided in this case:

(Show your work, calculations,and explain your answerswell)

Cost of Capital, Capital Structure, Hurdle Rate:

· What is the firm’s current Weighted Average Cost of Capital (WACC) at its current capital structure.

· Capital Structure theory addresses finding a firm’s optimal capital structure. How do you determine the optimal capital structure?

· What is the SPI’s optimal capital structure?(Complete the Cost of Capital & Capital Structure worksheet)

· Define Hurdle rate. What is a Risk-adjusted Hurdle Rate? Based on SPI’s current capital structure, what is the appropriate Hurdle Rate for the project?

Capital Budgeting:

· Please complete the capital budgeting analysis for this project. You should develop the incremental cash flows:

O Initial investment cash flow at t=0,

O Operating cash flows through the life of the project,

O Terminal cash flows

· You should evaluate the project using:

O Net Present Value,

O Internal Rate of Return,

O Modified Internal Rate of Return

· Present your decision whether the project should be accepted or rejected, and justify.

· Finally, Beatrice, a financial analyst at Fanning, has worked ½ time during the last year developing the project idea and proposal. She did not include her time in the project analysis you completed, however her supervisor believes that including the cost of Beatrice’s time in the cash flow estimates as an expense is appropriate. This amounts to $32,500 (one-half year salary + benefits). They have asked you how should this be handled (discuss)? That is, should it be included in the analysis? Why/Why not?

Answer 1

a. At current capital structure of D/E = 0.33,

WACC = D/A*Kd*(1-t) + E/A*Ke

Risk free rate	1.82%
Beta	1.37
Market risk premium	4.25%
Cost of Equity (Ke)	7.64%

Before tax cost of debt (Kd)	5.12%
After tax cost of debt	3.38%

For a high risk project, Hurdle rate = WACC + 2%

WACC	6.58%
Hurdle rate (High risk)	8.58%

b. The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) of a company while maximizing its market value. The lower the cost of capital, the greater the present value of the firm’s future cash flows, discounted by the WACC.

Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world optimal capital structure. What defines a healthy blend of debt and equity varies according to the industries involved, line of business, and a firm's stage of development, and can also vary over time due to external changes in interest rates and regulatory environment. Therefore, managers usually attempt to operate within a range of values.

Potential equity investors usually compare the amount of leverage other businesses in the same industry are using—on the assumption that these companies are operating with an optimal capital structure—to see if the company is employing an unusual amount of debt within its capital structure.

c. D/E = (D/A)/(E/A)

CAPM: rs = rf + b*market risk premium

WACC = D/A*rd(1-T) + E/A*rs

	D/A				E/A
D/E	(Wd)	rd	rd(1-T)	b	(Wce)	rs	WACC
0	0	0.00%	0.00%	1.12	1	6.59%	6.59%
0.33	0.25	5.12%	3.38%	1.37	0.75	7.64%	6.58%
0.50	0.333	5.25%	3.47%	1.49	0.667	8.15%	6.60%
0.75	0.428	6.75%	4.46%	1.68	0.571	8.95%	7.02%

From the above analysis, we can see that the firm has the lowest WACC at D/E = 0.33 (i.e. current capital structure is optimal capital structure)

d. A hurdle rate is the minimum rate of return on a project or investment required by a manager or investor. It allows companies to make important decisions on whether or not to pursue a specific project. For a project which is as risky as the firm's current business, WACC is the appropriate hurdle rate.

Risk-adjusted hurdle rate represents the level of minimum acceptable rate of return (MARR) for a specific project depending upon its riskiness. The Risk-adjusted hurdle rate describes the appropriate compensation for the level of risk present—riskier projects generally have higher hurdle rates than those with less risk. In order to determine the rate, the following are some of the areas that must be taken into consideration: associated risks, cost of capital, and the returns of other possible investments or projects.

Basis SPI's classification of the current project opportunity, it is classified as a high risk project and the appropriate risk-adjusted hurdle rate for this is WACC+2%

e. Given

Initial Investment ($)	5275000
Salvage Value ($)	95000
Variable Cost (% of Sales)	51%
Fixed Cost per year ($)	234000
Corporate tax rate	34%

Depreciation Schedule	1	2	3	4	5	6
Depreciation rate	20%	32%	19.20%	11.52%	11.52%	5.76%
Depreciation Amount	1055000	1688000	1012800	607680	607680	303840

WACC	6.58%
Hurdle rate (High risk)	8.58%

NOTE: 1. For MIRR calculation, the Hurdle rate is being used as the financing rate, while WACC is used as the reinvestment rate.

MIRR assumes that positive cash flows are reinvested at the firm's cost of capital and that the initial outlays are financed at the firm's financing cost.

1. Financing rate - It has been assumed to be the hurdle rate for the project, i.e. 8.58%
2. Reinvestment rate - Assumed to be the cost of capital for the firm, i.e. 6.58%

NOTE: 2. Initial Investment in Working Capital = Increase in Accounts Receivables + Increase in Inventory - Increase in Accounts Payable

Increase in Working Capital = 235,000 - 50,000 + 40,000 = 225,000

Time Periods	0	1	2	3	4	5	6	7	8	9
1. Initial Cash Flow
Capital Investment	-5275000
Working Capital	-225000
2. Operating Cash Flows
Sales		1250000	2875000	3450000	3795000	4174500	4591950	3903157.5	3317684	2820031
Variable Cost		637500	1466250	1759500	1935450	2128995	2341895	1990610.3	1692019	1438216
Fixed Cost		234000	234000	234000	234000	234000	234000	234000	234000	234000
Depreciation		1055000	1688000	1012800	607680	607680	303840	0	0	0
Pretax profit		-676500	-513250	443700	1017870	1203825	1712216	1678547.2	1391665	1147815
Tax		0	0	150858	346076	409301	582153	570706	473166	390257
Profit after Tax		-676500	-513250	292842	671794	794525	1130062	1107841	918499	757558
Cash Flow (PAT + Dep)		378500	1174750	1305642	1279474	1402205	1433902	1107841	918499	757558
3. Terminal Cash flow
Working Capital										225000
Salvage Value*(1-tax rate)										62700
Net Cash flow (1+2+3)	-5500000	378500	1174750	1305642	1279474	1402205	1433902	1107841	918499	1045258
NPV ($)	1186902
IRR	13.266%
MIRR	9.996%

Basis our analysis,

1. NPV = +ve : therefore, project should be accepted as it is value-adding to the firm

2. IRR > WACC : As the rate of return of the project is greater than the cost of capital for the firm, the project should be accepted.

3. MIRR > WACC : Even after accounting for the fact that intermediate cash flows may not be reinvested at IRR but at firm's own cost of capital, the rate of return is still higher than the firm's cost of capital/hurdle rate. Therefore, the firm should accept the project.

f. The one-half year salary + benefits of the financial analyst is a sunk cost for the business. It is a past and irreversible cash flow, and can not be affected by the decision to accept or reject the project. Hence, this cost should be ignored in NPV analysis.