Question

Think of a new project Dollarama Inc could undertake in response to the new business environment resulting form the COVID-19 effect. A potential project should last for 5-10 years and account for no more than 10%-30% of the firm’s overall operations.This project cannot be of average risk to the firm.

Using either the pure play or the subjective approach to estimate the discount rate, describe how you would adjust the WACC to find the discount rate for this project.

Describe which components of the project’s cash flows need to be considered if you were to calculate the NPV of this project. Be as specific as you can but no numbers are required, just demonstrate that you understand all the relevant cash flows for this project.

Will this project increase or decrease the risk of the firm? Which risk, systematic or unsystematic?

Answer 1

Answer with explanation :

Potential Project

Assuming the project can be from any industry i.e. it is not clearly defined which sector Dollarama Inc does business in already.

A project I would consider is opening online fitness classes. Given the changing scenario and the people already moving towards fitness regimes; post-COVID-19 will surely focus more on health and wellness.

Due to the risk of contracting the disease again - people would avoid going to gyms/fitness centers for an even longer time and this acts as an opportunity for training people from their homes itself.

Estimating the discount rate

Pure Play Approach

Steps :

• Calculate the beta for each division
• Calculate the Cost of equity using the CAPM for each division
• Calculate the WACC for each division using the for each division

Subjective Approach

Steps :

• WACC will be increased if the project is riskier than the firm's average
• WACC will be decreased if the project is safer than the firm's average.

The Subjective approach is more commonly used than the pure-play approach as it is easier to implement, given the project is safer than the firm's average WACC will be decreased.

Components of Cash Flows to be considered for Online Fitness Classes

1. Initial Cash Flows: Initial cash flow for this project would be investments on buying gym equipment, buying a space for conducting classes (if not renting), investments on cameras and other expensive equipment to start the project, setup costs for app/online system.
2. Operating Cash Flows: For this project, the operating cash flows would be the Salaries paid out to the trainers and employees, cash paid to vendors and suppliers, regular outflow to maintain the app, and Cash collected from customers/subscribers.
3. Terminal Cash Flows: Cost estimated from the disposal will be relatively few, however, it can be types of equipment from the gym and other cameras which can be disposed.

Risk – Increase or Decrease

This project will decrease the risk of the firm given that the firm NPV would be relatively positive and < 1 throughout the lifetime.

Type of Risk

The type of risk that can be mitigated or eliminated is an unsystematic risk. Given a firm is diversifying into different operations; it is reducing the operational risk.